Extreme Tech Shorts

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.


2 Responses to “Extreme Tech Shorts”

  1. Robert Says:

    I understand what you are trying to do but I’m not certain that the techniques really work. I wasted a lot of time and money wishing that clearly overvalued tech stocks would fall, but you know what they often didn’t fall within the time frame that I needed them too. One of the best overvalued high tech stocks was Parkervision yet it maintained its stupid valuation for many years without profits, that is much longer than I can wait.

    Here are a few thoughts:
    1) If stock shorting is strictly a trading strategy than why should fundamentals play any role in the the strategy
    2) All fundamental valuation is at its essence a differential value analysis, as such it is a differential derivative strategy and is best executed as a differential derivative strategy

    • techshort Says:

      I understand what you are saying, and experience similar frustrations. I try to improve my chances by:
      * short as large a market cap as possible, while maintaining the very-worst fundamentals (no real revenues or products, high cash burn, limited cash, and if possible, debt).
      * low short interest – when I last looked at Parkervision, short interest was quite high
      * if possible, short on spikes – this is not easy, as during the spikes, it’s harder to get locates, and if you do, you sometimes get a buy-in squeeze on settlement day.

      Since starting the extreme alpha short strategy in November 2009, we are up 8% net (vs Nasdaq +6%). But it has not been easy. Because we have been so picky and locates are hard to get, we only hedged 20% of the portfolio, which hurt overall performance. We incur high borrowing costs on some stocks, which reduced performance of the fund ex-cash by 1.2% already. We suffered through severe price spikes, where two of our stocks tripled in value (and have finally come back down), we averaged up as much as we could within risk-diversification, locate, and buy-in constraints.

      I particularly share your pain on how some of these stocks never reach their fundamental value of near-zero. Whether it’s Parkervision ($65M mkt cap) or Research Frontiers ($53M), they seem to have an endless supply of retail investors that buy into these hyped companies with no real revenues. At some low market cap point, we would cover, even if it remains overvalued, depending on borrow rates, financial condition, product upside, etc.

      On your two thoughts:
      1) For me, this is not a trading strategy. I am a fundamental investor.
      2) What do you mean by a differential derivative strategy?

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