AdThink Media: Company Visit

November 26, 2010

I recently visited AdThink Media (ALADM, France-listed) at their headquarters near Lyon, France. AdThink operates in the internet media business, which in France, is less-penetrated and faster-growing than the slower-growing, more-competitive US market. Only 55% of France’s 70M inhabitants use the internet today. 15k new internauts enter the French market each day.

Furthermore, France is a very difficult market for foreign firms to crack. Google just opened up an office in Paris. Others have not been able to take the plunge. This places AdThink, and a small number of French competitors, in the enviable position of visible high-growth for the next three years. In fact, the most likely scenario will be for large international players to acquire French internet media companies to gain market access.

I liked the work ethic and structure of the 85 AdThink employees. There has been no voluntary turnover. Lyon is a bit more stable workplace than Paris, and certainly steadier than the US or Asia. The average age is 29 years, and they have been working and learning together over the past few years. They have a high energy level – most people were plugging away when I left at 6pm. Three separate teams run independent profit centers in a very entrepreneurial way. The result is that new products and concepts are continually introduced and monetized by a wide base of employees.

AdThink Media estimated 2010 revenues of €25M ($33M) are derived from Online Publishing (57% of first-half 2010 revenues), and Audience Monetization / Traffic Acquisition (43%). Internet Publishing includes dating, digital games, IT professional sites, and a men’s site (unhomme) similar to GQ in the US. Dating and games have rapidly growing subscriber bases, and are subscription-based pricing. IT Pro and unhomme are advertising based, as well as selling certain user data. The most promising is dating and games, which have high potential.

Audience Monetization is achieved via Advertstream and Adsmarketplace. Advertstream can be viewed as an online ad agency with a core specialization in cooking, family and women. Advertstream covers several web sites with 26 million unique visitors. Advertstream’s technology targets its audience and analyzes user behavior, leading to very specific user profiles for commercial clients such as Nestlé. Adsmarketplace is an online market for internet publishers to sell their sites’ ad space to commercial bidders. Adsmarketplace has 11,000 internet site publishers and 10,000 commercial bidders. Adverstream is also used for direct online performance marketing based on banners, email routing and click-throughs. The company also has a very promising micropayment platform that should add a lot of value to the group in the next few years.

First-half 2010 revenues rose 24% from last year to €10.7M. Audience Monetization / Traffic Acquisition revenues rose 48% in the first-half of 2010 led by a 132% jump in Advertstream-related sales. Online Publishing sales rose 10%. The biggest improvement came at the bottom line. Net profits excluding amortization of goodwill from acquisitions was €0.3M versus a €1.3M loss in the year-ago period, driven in part by lowering dependency on expensive Google ads as well as an improved product mix. First-half net profit including goodwill amortization was €0.015M. Moreover, management gave extremely high guidance for the second half of 2010 with EBITDA of €1.5M to €2M, versus €0.5M in the first half, and a 10% EBITDA margin for the full year. These numbers were re-confirmed during my November 2010 visit.

2010 revenues should rise by 28% to €25M, after increasing 25% in 2009. We expect a similar rise in 2011 and 2012 revenues aided by a number of new products coming out including a powerful micropayment platform, international expansion of certain product groups, more aggressive positioning of dating and digital gaming web sites now that critical mass has been reached, and other initiatives. Moreover, Advertstream’s rapid growth should continue unabated. Operating margins should rise from 5% in 2009 to 10% this year, and should rise to 12% next year. Operating margins should reach 15% by 2012 and near 20% over the long run. Larger-peer Rentabiliweb (BIL, Belgium) has operating margins near 20%. Similar-size Weborama (ALWEB, France) and Adverline (ALADV, France) are at 20% and 10%, respectively. Ramping revenues and margins should create explosive bottom-line growth, as seen in the projections below.

€, million 2006 2007 2008 2009 2010e 2011e 2012e
Revs 3.5 8.6 15.6 19.5 25.0 32.0 40.0
%chg +140% +145% +80% +25% +28% +28% +25%
EBITDA 0.36 0.95 0.69 0.93 2.50 3.84 6.00
mgn 10.3% 11.0% 4.4% 4.8% 10.0% 12.0% 15.0%
Net Inc 0.24 (0.28) (0.99) (1.12) 1.20 2.05 3.60
mgn 7.2% (3.2%) (6.3%) (8.0%) 4.8% 6.4% 9.0%
EPS NA (0.06) (0.20) (0.22) 0.24 0.41 0.72
%chg NA NA NA NA NA +71% +76%

AdThink Media is at the profitability inflection point where fixed costs are now covered and major investments are in the past, so that the contribution margin of incremental revenues is very high. Few new employees will be needed to generate strong revenue growth for at least the next three years. This scalable business model is very attractive.

Currently priced at €2.97 with just under 5M shares outstanding, Adthink’s current market cap is €14.8M. Enterprise value is €14.4M after subtracting net cash of €0.4M, which is only 0.6x 2010 revenues. AdThink is trading at 12x 2010 EPS of €0.24, and 7x 2011 EPS of €0.41 (or 9x 2010 EPS of €0.34 excluding amortization of goodwill from acquisitions, and 6x 2011 EPS of 0.50 excluding amortization of goodwill from acquisitions). Cash is expected to increase to about €5M by the end of 2010 (versus €3M at midyear), and debt should decline to €2M (versus €2.6M at midyear).

AdThink Media has a cheap absolute and relative valuation versus peers. EV / 2010 EBITDA is only 4x, and profits are growing exponentially off of a low base. French peers have an average EV / 2010 EBITDA multiple of 12x.

Why is AdThink so cheap?

* it is a microcap with low but recently growing liquidity
* it was not a profitable company until recently, although that was due to heavy past investments that are now bearing fruit
* some Parisian investors feel that the quality of technology people in Lyon are less than the grandes écoles of Paris
* currently lacks the scale of some of its larger competitors like Rentabiliweb

What are the risks?

* dependence on Google – although lowered to 50% of ad costs in 2010 versus a much higher / expensive level in prior years, and was achieved without sacrificing traffic via technological enhancements
* advertising is economically sensitive
* saturation of the market in about 4-to-5 years when France penetration rates approach 80%-to-90% (versus 55% today)

AdThink is not going back into the red for the foreseeable future, and in fact, should exhibit extremely strong profit growth given their scalable business model and fast-growing, somewhat protected market. When you add the fact that it has a dirt-cheap valuation, the end result is an expected return of a multiple of its current share price over the next 18 months.

Takeaways from Broadband World Forum in Paris

October 27, 2010

Yesterday, I attended the first day of the Broadband World Forum in Paris. Broadband World Forum and ITU’s Telecom World are the two remaining high-impact global telecom vendor trade shows now that Supercomm has faded away.

There was a lot of excitement at the show. An Alcatel-Lucent (ALU) IP Routing salesman said business had never been better. Global themes of cloud computing, mobile broadband, smart phones, rising video traffic, etc. have now filtered down into rising demand on the telecom infrastructure that needs to accommodate this exponential growth in bit traffic. Resulting telecom broadband initiatives at the show included:
* 100GB telecom switching platforms (and discussions of when it will be adopted)
* Mobile backhaul – and whether to use lower-cost microwave or more scalable ethernet platforms
* FTTP – fiber-to-the-home will be a much longer process than previously thought
* Traffic monitoring – which ultimately leads to heavy users paying more
* Digital Home network with all electronic devices wirelessly controlled

I also had an interesting telecom vendor economics discussion with an industry veteran. As opposed to certain software and internet business models with high margins, price setting capabilities, and low fixed costs, the telecom equipment sector is basically “box movers”. Price is a given. A limited number of powerful carriers have leverage over multiple suppliers (and system integrators like Alcatel-Lucent squeeze even harder on their suppliers, in order to earn a decent margin when selling to carriers). Technology can be a differentiator, but it really is more of an entry ticket. If the technology is not top-notch, you don’t play. Thus, the key to a successful telecom operator is cost. The low-cost producers are more profitable, and the higher-cost producers are less profitable.

For example, Adtran (ADTN) is a strong telecom switching company that successfully competes against larger competitors like Alcatel-Lucent and Cisco, and has been more profitable than most of their competitors due to their no-frills way of doing business. For example, Adtran cheaply acquired Luminous Networks’ (a Quan Ventures II portfolio company) IP about five years ago. They took Luminous’ industry-leading resilient-packet-ring gigabit ethernet protocol for metro access, simplified it into a lower-cost solution, and is now a leading gigabit ethernet network supplier. Adtran is now benefiting from the ethernet mobile backhaul boom, again with a low-cost, strong technology offering for major carriers.

In every niche I explored at the show, no one company had a product that another was not at least developing. For example, Juniper Networks (JNPR) was the first to announce a 100GB switching platform. But Nokia Siemens Networks (NSN, private) and others will be launching 100GB within twelve months. Moreover, most providers have lambda grooming products and other features that lower the cost of the existing central office switches and add capacity that can elongate this transition period. Juniper had the best differentiation attempt through their own venture-backed “apps farms” where start-ups write customer-demanded apps like video surveillance that are difficult to support internally.

An interesting statistic was that broadband spending is projected to grow by only 3.4% annually through 2015, and total telecom spending would be roughly flat. Thus, vendors need to innovate just to stay even, in spite of the macro opportunity of the broadband boom. Vendors stuck with maturing circuit-switching or ADSL products for example will be hurt the most.

Previously, certain groups in the US (namely Verizon, certain cable operators), Korea, Australia, Germany (namely Munich municipal authorities), among others, have had fiber to the premise (FTTP) or home initiatives. A counter to this trend at the Forum was to make the most of the existing copper infrastructure at a much lower cost. NSN demonstrated a 750 Mbps speed over a 500 meter distance using bonded copper cabling. Alcatel-Lucent and Huawei had similar technology demonstrations previously that can be generally labeled as Phantom DSL. Ikanos Communcations (IKAN) announced NodeScale Vectoring at the Forum that will enable greater than 100 Mbps speeds over longer distances than previous DSL technologies covering 192 nodes or local connection/distribution points. Bonding VDSL (very-high-speed digitial subscriber lines) today, vectoring VDSL in 2011, or Phantom DSL longer term, are all part of a broader movement to extend the capacity of today’s current copper infrastructure to meet future broadband needs. In a world where long-term carrier capex growth is limited by the difficulty of monetizing growing bandwidth demand (as well as a maturing voice revenues), momentum has been growing from a number of large service providers (AT&T, BT, Qwest, Windstream, Tele2, TDS, etc.) to leverage existing copper to deliver broadband data and video. Over the next few years, the most common strategy will be fiber-to-the-node or local distribution point (FTTN), with copper covering the last 500 meters via VDSL.

Ikanos Communications, a company that we have written about previously, should generally benefit from these high-speed copper and FTTN trends. The VDSL market is growing in excess of 20% annually. On the other hand, Lantiq (private) is a venerable VDSL competitor, that along with Broadcom (BRCM), has recently taken VDSL market share away from Ikanos. Ikanos VDSL market share was 82% on a pro-forma basis in 2008, was 73% in 2009, and will be lower in 2010. In addition, Ikanos has decided to walk away from certain commoditized ADSL business. Thus, we expect Ikanos revenues to decline in 2010, and show single-digit growth in 2011, while profitability should improve substantially next year. The yet-to-be-reported September quarter had substantial restructuring charges and a lower revenue run rate, which led to a plunge in Ikanos stock price. IKAN was trading at above $3 earlier this year, and is now at $1.15, leading to a current market cap that is only 0.4x depressed 2010 revenues.

Ikanos: Lessons Learned

August 25, 2010

Ikanos (IKAN, $1.00) is a stock that has lost half of its value since my previous article on June 4th. The overall positive article seemed to make sense, and was supported by meetings with top management. The shares appeared attractive at the time with EV/Revs 0.4x, P/E of 9x 2010 and 5x 2011 EPS (non-GAAP), a large net cash position, and a reversal of fortunes with positive non-GAAP earnings in the last few quarters.

So, What Went Wrong? And Where Do We Go From Here?

A few lessons learned:

1) Value investing in technology is very tough. Value investing requires more certainty in numbers. Technology, however, is dynamic and more uncertain than most sectors. Thus, the numbers should not be overly relied upon as I did with Ikanos.

2) Know what you don’t know, and maximize what you do know. As a research-focused institutional investor, perhaps I knew 10% of what was happening. That still leaves 90% that I did not know. I should have known more and not taken short cuts. I should have walked the floor at some trade shows where I could have talked to the sales people, competitors, and customers. This would have increased my “understanding” to a hypothetical 20%, still not 100%, but would have improved my perspective and lowered my stock-specific risk. The other 80% is really beyond one’s control; creating the need for a diversified portfolio (and if possible, a long-short portfolio, which we have done with our Quan Technology Fund).

3) Respect the tape. IKAN’s market action was weak since April, and I did not respect the tape. It did not help that I rationalized that the stock was too cheap to sell when top management was let go.

On August 4th, the new management team dropped the bomb, announcing a projected Q3 $15M revenue shortfall versus Q2 (and related restructuring charges to accommodate the lower expected revenues). The stock tanked.

What am I doing now:

I have learned more about what is going on at Ikanos, and have added to our fund’s position recently. There is no short-term fix to some of the problems that Ikanos has had in the marketplace. But the correct measures were implemented, and I am comfortable with the team and the path they are taking.

I am taking a long-term view. In the interim, the stock may weaken more despite today’s extremely low valuation. Investors always overreact on the downside as well as the upside. Furthermore, the Rule of Three says that there is never just one bad announcement, but a series of three. So, there could be more bad news ahead. While I am tempted to say that it is in the price, rule #1 above, makes me less adamant.

It is also possible that IKAN can move up in the months ahead. The lower opex and higher gross margins milestones should begin to appear in Q4, which may create stock support. The revenue growth measures will take longer to implement.

Let’s Go Fly A Kite Update: CareView Communications Is Still Flying

August 15, 2010

This is a follow up on our CareView Communications (CRVW) note written April 25th (see my Let’s Go Fly A Kite article via link

CRVW’s price has dropped from $2.34 since our April article to $2.04 (as of August 13). But the market cap remains bloated near April’s levels at $258M including 10.6M shares issued at $0.52 per share in the second quarter. This 125.5M share count excludes the effect of 7M in warrants with a strike price of only $0.52, or the effect of potential payment-in-kind shares.

CRVW provides video monitoring of hospital patients, that can then be linked into local area networks or internet feeds with medical staff and patients’ families. There is not any real proprietary technology. A service business model plans to charge a monthly service fee of $60 per month to the hospital and $13 per day to the patient plus a transaction fee. But no material revenues have been generated yet.

In fact, CRVW’s financial performance continues to be abysmal, first-quarter 2010 revenues were a measly $42k, net loss was $3.1M, but cash from operations was only negative $0.6M due to major non-cash expenses such as using shares as payment. Over the twelve months ended March 2010, revenues were $0.1M with a net loss of $8.2M.

So why has CRVW stock rocketed 94% year-to-date despite the weak financials? The company accelerated its equity raise with $5.5M in additional capital early in the second quarter, which replenished a cash balance that was down to $33k on March 31st. Supposedly, this caps the equity offering. The downside is that it was done at a 75% discount to the current stock price.

A second reason for CRVW’s positive market action so far in 2010 was the company had positive news releases this year: a lease financing agreement with Fountain Partners, a US East Coast distribution agreement with Foundation Medical, an irrelevant release on a filing of a bed sore patent (based on moving the patient around using its monitoring system – that does not sound novel or defensible), and a China JV announcement. However, the China JV announcement may be a bit premature. It is only a signed letter of intent to enter into a joint venture, subject to execution of definitive contractual documents, which if executed would give Weigao Holding an exclusive license to manufacture and distribute the CareView System in China. Thus, providing no more than a royalty stream to CareView, if the agreement is ever executed and honored. In sum, these news items were more fluff than substance.

But suppose I am wrong, and there is more to these announcements than meets the eye. What are the chances that revenues will reach the $100M+ revenues and $10M+ profits with the current share count to justify today’s $258M market cap? Can management completely reverse its losing streak of nominal revenues of under $200k for each of the last five years, with negative gross margins since 2008, and net losses doubling each year to the current bloodbath of $8.2M? The probability is extremely low that management will be able to penetrate that many hospitals, and then charge and maintain these prices, for a low-tech video surveillance service despite the attached marketing bells and whistles (e.g. Baby View, Movie View, etc.).

The answer to the question of why CRVW has nearly doubled year-to-date to such a bloated market cap does not lie in fundamental analysis. It lies in the nature of the OTC retail market where news and stock prices can move in exaggerated swings, and that for technical reasons, some of these technical upswings can be maintained for longer-than-expected time periods.

Specifically, there are some powerful backers of CRVW including Chairman of the Board – Tommy Thompson. Mr. Thompson had served as the Secretary of U.S. Department of Health and Human Services under President George W. Bush, and prior to that was the Governor of the State of Wisconsin for 14 years. T2 Consulting owns 13% of CareView. Other Board members include Craig Benson, the former Governor of New Hampshire, and some other well-connected businessmen. These deep-pocketed insiders can provide the cash funding and connections to keep the stock price at elevated levels for some time. Secondly, April’s cash replenishment should also delay bankruptcy risk for a few quarters, providing quasi-fundamental stock price support. Third, the hyping of news flow amongst retail investors of the OTC markets creates short-term price momentum. Finally, the nature of the OTC bulletin board and pink sheet exchanges which disadvantages short sellers also lends stock price support (for more details, please see my Gravity article dated March 24th at

Technical support factors in the end will be trumped by the tens of millions of shares owned by insiders at a fraction of the current market price that will be coming out of lock-up in the coming quarters. Even if Board members continue to restrain themselves from realizing tens of millions of dollars in paper profits, the wider base of retail investors and vendors that participated in the more recent large financings should be rushing to exit anywhere near the current price of $2.04 with a cost of 52 cents a share.

Fundamentals should also bring CRVW down to earth. Unless there is a complete reversal of financial results, CRVW will be facing bankruptcy risk over the medium term, and then will likely have to resort to issuing shares like candy to remain solvent, at the expense of current shareholders.

You would think that investors should make a bundle in shorting extremely overvalued stocks with no fundamentals like CRVW. But if it were that easy, then these ridiculous valuations would not exist in the first place.

Disclosure: Short CRVW

Ikanos – An Extremely Undervalued Stock

June 5, 2010

In my previous blogs, I have written about grossly overvalued stocks that should be shorted. Today, I would like to discuss an extremely undervalued technology stock, and briefly point out the stark valuation contrasts to our short candidates.

Ikanos (IKAN, 2.04) – market cap $113M with $22M net cash, EV/Revs 0.4x, P/E of 9x 2010 and 5x 2011 EPS (non-GAAP).

We are familiar with this company’s broadband xDSL chipset business, and in fact, made a venture investment in one of its predecessor companies – Virata – in 1998. Broadband demand will continue to grow. Broadband subscribers should jump from 469M in 2009 to 782M in 2013, creating a 2013 TAM of $3.2B for xDSL, fiber, and cable modem semiconductor vendors. One knock on Ikanos is its exposure to xDSL, notably ADSL, which gives them a lower growth rate than pure fiber peers. But Ikanos has a larger exposure to the faster growing VDSL market (and 73% VDSL chipset market share), a stealth PON program for FTTH/N, and steady-growing communication processors. We project revenues to grow 8% in 2010 to $233M versus pro-forma 2009 revenues (including some commoditized ADSL business acquired from Conexant that management has de-emphasized).

Ikanos should continue to benefit from economies of scale derived from last year’s merger with Conexant’s Broadband Access division. Previously, Ikanos was half the size and unprofitable. Post-merger operating expenses have decreased to 40% of revenues versus 60% pre-merger. Consequently, the company became profitable in the last two quarters, with non-GAAP EPS of $0.03 (Q4 2009) and $0.04 (Q1 2010). Sequential improvement should continue this quarter as gross margins are expected to rise 3% percentage points to 46%, with no decrease in sequential revenues and little change in operating expenses. We expect 2010 EPS to reach $0.23.

Ikanos is deeply discounted versus its peers’ EV/Revs of 2.4x (vs 0.4x for IKAN), and P/E of 22x (vs 9x for IKAN). Even applying a 20% discount to peer multiples, our target price is just below $5.40 (+163% from today’s closing price of $2.04). We took a blend of our 2010 and 2011 estimates for Revenues, EBITDA, and EPS, and then applied those discounted peer multiples with a greater weight on the P/E multiple.

Why is IKAN so cheap? First, the stock has historically been unprofitable and may need a few more quarters to prove itself and get a wider following. Secondly, gross margins unexpectedly declined sequentially from 44% in Q4 to 43% in Q1; while the CEO left at around the same time. The stock got whacked by about one-third since mid-April. Gross margins are expected to bounce back as product mix normalizes again. As for the CEO, he left on his own accord because of differences with Chairman Dado Banatao. Dado is the founder of Tallwood Ventures, the largest shareholder of Ikanos. Dado has a pedigree semiconductor background, and has a vested interest to maximize the value of Ikanos (and has successfully done so for similar companies in the past). In fact, previous SEC filings disclose that Tallwood and a number of other parties made pending bids as high as $4 per share for Ikanos back in 2008.

Dado is a self-made man, and may take a more aggressive approach than previous CEO Mike Gulett. This may ruffle some feathers among employees, which can be considered a risk or benefit. A medium term risk is the sinking Euro where 25% of Q1 revenues were generated. While Ikanos prices in dollars and even has some local Euro costs, ASPs could come under pressure. Management said that there was no price concessions from customers when the Euro previously rose; so customers should not balk at pricing now (and so far, have not). Still, it is a risk. Also, Ikanos will need to offset the maturing, lower-margin ADSL business with new products such as Vector-based VDSL, PONs, and digital home networking initiatives to sustain its competitive advantage and improve its sub-industry average revenue growth. That is, if the company is not sold beforehand.

Time is on our side if we continue to short the absolute worst technology stocks, while being long the cheapest, growth tech stocks in the world. Ironically, Ikanos’ enterprise value is between one-half and one-quarter of the EV’s of the two short stock candidates that we discussed in my previous blogs, despite the fact that both of those companies still have no revenues or marketable products, and are incurring heavy losses. It’s hard to imagine that such a wide valuation discrepancy is sustainable.

Let’s Go Fly A Kite

April 25, 2010

Let’s go fly a kite
Up to the highest height
Let’s go fly a kite
And send it soaring

Up through the atmosphere
Up where the air is clear
Oh, let’s go, fly a kite

CareView Communications (CRVW) is that “kite”, and its stock is soaring into the stratosphere and beyond.

CareView attempts to provide video monitoring systems to health care providers. The term “attempts” is used because, up to now, they have barely sold anything. Revenues were only $87k in 2009, and were even less in 2008. The company had a net loss of $6.2M and negative EBITDA of $3.4M in 2009, doubling the negative results from the prior year. No news of any substance has been released so far in 2010. As of December 2009, debt was at $2.5M and cash was at $0.2M.

What appropriate market value should be assigned to this company? Well, today (23 April 2010, $2.34 per share) it is trading at a market cap of $254M.

Welcome to the world of the OTC bulletin board and pink sheets where a Christian video games company (EARI) with no product yet still has a market cap of $510M after falling 30% since our blog last month. We would have shorted EARI a long time ago, but we have yet to locate any shares. However, we were able to short 25k shares of CRVW net of buy-ins, and are currently losing a bundle as it more than doubled over the last month. We have been average-shorting-up when shares were available.

The major risk is the powerful insider Board members that are backing the company. The Chairman of the Board is Tommy Thompson. Mr. Thompson had served as the Secretary of U.S. Department of Health and Human Services under President George W. Bush, and prior to that was the Governor of the State of Wisconsin for 14 years. T2 Consulting owns 13% of CareView. Other Board members include Craig Benson, the former Governor of New Hampshire, and some other well-connected businessmen. The CEO is an industry veteran. The COO increased his stake in the company to 12% in 2009 when the stock usually traded at around $1.

A secondary risk is that management makes a huge announcement about signing up customers. Any such announcement will have a low probability of justifying the current valuation. It may create further pumping fuel, or also lead to a sell-on-the-news market reaction.

Up to now, the insiders and market-maker had the firepower and trading techniques to resist short sellers and hold the stock at around a $1 low in 2009 (or $100M+ market cap), despite the extreme overvaluation. Apparently, they have the ability to push the stock even higher today to $2.34 versus $1 only one month ago.

I am not sure how much longer this will last. But it is only human nature for insiders to cash in some of their tens of millions in paper profits. One possible sign of a top is when no more shares are available to lend to shorts for a while. This occurred last Friday, after recently being bought-in earlier in the week. If this continues, then there is a good chance that the stock sales are being saved for insiders and other natural sellers, and the stock should start declining in the medium term. Where it goes over the coming weeks is anybody’s guess.

You would think that investors should make a bundle in shorting these extremely overvalued stocks with no fundamentals. But if it were that easy, then these ridiculous valuations would not exist in the first place.

As a side comment, I just saw Mary Poppins with my 9 year-old daughter, and we both loved it.


March 25, 2010


I have always been amazed at how certain stocks with no revenues, heavy losses, weak balance sheets, weak prospects, and questionable management can obtain exaggerated market caps sometimes in the hundreds of millions of dollars. These stocks can defy gravity for longer-than-expected periods, especially during bull market runs. Eventually, the stock prices deflate, although the market caps decline more gradually due to a rising share count.

First, I would like to address how gravity can be defied for substantial time periods. In recent years, Reg SHO and other measures were introduced to curb naked shorts and generally protect smaller stocks. A by-product of Reg SHO, however, was to shelter promotional penny stocks that are pumped up by insiders. Previously, it was easier for the market mechanism to efficiently price these stocks. The biggest challenges today are locating shares, avoiding buy-ins, dealing with excessive margin maintenance requirements on sub-$2.50 per share stocks, obtaining reasonable borrow rates for an extended time period, dealing with OTCBB and Pink sheet market makers that manipulate stocks. Unlike Nasdaq, there is no requirement to respect the best bid and offer, nor is there any requirement to honor locates – creating a short squeeze on settlement date or thereafter. So currently, a tightly controlled float, high borrow rate, feisty market maker, low stock price, good promoter to pump the stock, and deep-pocketed backers that fund the cash burn, can lead to an inefficiently priced stock that is difficult to crack.

(As a side point, is it fair to protect these pump-and-dump stocks, where insiders get rich at the expense of unsuspecting retail investors? Is it correct for OTCBB and Pink sheet exchanges to treat investors differently? Is it necessary to create arbitrary margin maintenance requirements on faulty math assumptions that protect penny stocks from being shorted?)

So how does gravity bring these stocks back down to earth? Dilution to fund these negative cash flow business inflates the market cap, as does pumping up the shares on speculative news. A rising market cap with no fundamentals often creates more short interest (overcoming the above-mentioned barriers) and greater insider selling. Finally, a macro downturn that sucks liquidity out of the market is a death knell for most of these pump-and-dump stocks.

I read a post by stockerblog from February 2007 on fuel cell stocks (
An indicative sample of the extremely overvalued stocks mentioned in the article were decimated. ECOtality (ETLE, price/sales of 137x in Feb 2007) fell from about 100 to 5. Hydrogen Engine Center (HYEG, P/S of 411x in Feb 2007) went from 3.25 to 0.06. Medis Tech (MDTL, P/S of 900x in Feb 2007) slumped from 17 to 0.07. Normally, once these stocks begin their downward spiral to earth, they never fly again, although ECOtality is trying to resurrect itself. All three of these stocks experienced declines since February 2007 which then accelerated during the market crash at the onset of 2009.

Sometimes, however, these pump-and-dump stocks can crash quickly irrespective of market conditions. This can be due to a confluence of factors such as how high was the market cap inflated, initial low short interest levels, solvency fears, insider lock-up expiration, just to name a few. For example, over the weekend, I posted a blog on Entertainment Arts Research (EARI) at $9.80. EARI fell 30% in three trading days to close at $6.90 on Wednesday, but still sports a market cap of $500M (

Sooner or later, gravity wins.

Disclosures: No position is currently held in any of the stocks mentioned in this article.

Extreme Tech Shorts

March 21, 2010

Entertainment Arts Research (EARI, 9.80, 19 Mar 2010)

Mkt Cap: $714M, Revs (LTM): $0, Loss (LTM): ($1.3M), Net Cash: ($0.3M), Short Interest: 0.3 days

EARI produces faith-based interactive video games and “edutainment”.

EARI chart 100319

This is the perfect fundamental short.

The stock is fairly new on the scene, so there is little short interest. It has an extremely high market cap of $714M.  It has been over-hyped recently, leading to a speculative spike in the stock price. Despite the hefty market cap, no revenues have ever been earned by this company. Promises of future revenue are based on still-to-be-developed products. The web site shows nothing more than a home page.

The skyrocketing stock price is primarily driven by the Universe of Faith (UOF) – a virtual world designed for the faith-based Christian community that was developed by EARI’s President Jonathan Eubanks. The Legacy Group Global (LGG) advertising agency will work with EARI to make the Christian community aware of faith-based video games, online avatar opportunities to express their faith, etc.  Adding to the speculation, was a second announcement of providing content for distribution through the Shaolin Temple of China.

In EARI’s press release about partnering with LGG in the UOF launch, Damon Davis, CEO of LGG, stated “History repeats itself. The Word of God, since the beginning has moved by being carried through the mouths of men and women who believed in the life changing, penetrating word of Truth. Whether it’s a bush pilot carrying Bibles in the back of a fixed wing airplane into the jungles of South America or an avatar of Joel Osteen in front of a virtual community of 2 billion people worldwide, it will be his mouth delivering this word to a community that will spread this message like wild fire to the four corners of the globe. UOF provides that and we are committed to its success.”

While I do not underestimate the power of the Church, my faith in this business venture supporting a market cap of anything close to $714M is being severely tested by past real-world experiences. Let’s look at the fate of Left Behind Games (LFBG), an EARI peer. At $0.0044 per share, LFBG has lost 95% of its market value from its June 2009 peak. They also produced interfaith video games, and claimed to have a large distribution agreement with Wal-Mart. The current market cap is $8M, losses were $6.8M on revenues of $0.1M. To support their loss-making operations, LFBG had to issue billions of shares at dilutive prices.

While some may try to argue that the quality differential between EARI and LFBG is greater than the market cap differential of 87x, the bubble created in EARI stock is even harder to dismiss. Even if EARI reaches millions of zealous Christians above the poverty line over the next five years, the ability to monetize those viewers to justify the current market cap is highly questionable. Just converting church-goers/television evangelists into online gamers and avatars, forget even monetizing them, will be a daunting challenge.

According to EARI’s only-two news releases, video content will start being released this month for UOF, and by Christmas for the Shaolin Temple venture. Time will tell.

Background on the Author:

I am a manager of a tech stock hedge fund. Today there is an opportunity to short extremely overvalued, fundamentally flawed tech stocks. My Fund aims for the very worst tech stocks with market caps over $50M, nominal revenues, heavy losses, low net cash or preferably net debt, little proprietary technology, and other qualitative and quantitative factors.

The biggest challenges are locating shares, avoiding buy-ins, dealing with excessive margin maintenance requirements on sub $2.50 per share stocks, and obtaining reasonable borrow rates for an extended time period.

In spite of these challenges, the strategy has worked quite well on an absolute basis since last year, despite the rising stock market.

From time to time, I will post company and market research notes. I will also disclose if my fund has a position in these companies when posted.

I would welcome any comments from peers who would like to share their experiences, or other investors who would like to learn more about shorting tech stocks.