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 Purchase Jon's new book. SuperModels Recent articles: • 15 gritty survivors worth a gamble, 5/7/2003 • Hey, Modelman, answer me this, 4/30/2003 • Stocks with a peace dividend, 4/23/2003 More... | SuperModels The muddy waters of Digital River In recent weeks, stock in this Internet software maker has risen to levels not seen in more than a year, and it finished 2002 with its first two profitable quarters yet. Or did it? By Jon D. Markman Apparently, a few of you did not shop enough last month while awaiting the wars end. Retailers reported their April sales in the middle of last week, and large chains like Wal-Mart Stores Investors reacted explosively, and, in some cases, counterintuitively:
So which of these stocks will ring investors cash registers over the next two years -- the sure thing, the beat-up thing or the next new thing? Shunning shiny stocks If theres anything investors should have learned from the bear market, its to be skeptical but cautiously bold. So while I admire the business plans of both Whole Foods and Digital River, I lean toward the stock of Trans World. After all, not much has to go right at Trans World for the stock to double in the next two to three years. It is still very cheap versus its own history and its peers, with a price-to-sales multiple of 0.11, versus an industry average of 0.5, and a price-to-book multiple of 0.35. In better times, it has sold for a price-to-sales multiple of 0.25 to 0.95, so there is plenty of room for a multiple increase. Debt is not excessive. And at the end of last month, the company said it expects earnings to come in at 15 cents to 20 cents per share in fiscal 2003, ending January 2004, on sales about even with 2002 levels. To win in this stock, you don't need growth, just the sort of stability that would lead to modest analyst upgrades to market weight, a moderately higher multiple and a move into more small-cap mutual funds as an economic-recovery story. Short interest is very heavy, so there is lots of fuel for a squeeze. Meanwhile, director Robert J. Higgins and Chief Financial Officer John Sullivan were loading up on the stock in the mid-$2 range from October through April -- including many purchases in mid-March at recent lows. A move to $7-$8 by 2005 seems reasonable. Whole Foods isnt doing anything wrong; it will probably move up slowly and steadily, weighed down by expectations for future success as great as its past. Digital River, on the other hand, could see turbulence. The reasons will take a little longer to explain. Digital Rivers muddy earnings waters The Minnesota company is best known for an e-commerce platform that helps companies like anti-virus software maker Symantec Fast forward from there as it mounted one of its patented screaming moves higher until peaking around $18 on Tuesday amid renewed enthusiasm about e-commerce. On April 23, executives reported a first-quarter net profit of 13 cents a share and revenue of $24.6 million, compared with a loss of 13 cents a share on revenue of $18.1 million in the same period the prior year. What's not to like? Digital River ended 2002 with its first two seemingly profitable quarters since the companys inception -- and management expressed optimism about their prospects amidst sustained weakness in the technology sector. In an interview Tuesday, chief executive Joel A. Ronning said the firm has a wonderful business model. Were at the front end of software delivery via the Internet and a leader in e-commerce outsourcing -- areas that are coming together consistently now and over the next 3-5 years, he said. Yet, a detailed review of the companys SEC fillings by my colleagues at Camelback Research Alliance has unearthed a series of factors that cast concerns upon the quality of those earnings:
Digital Rivers earnings reports suggest the company enjoyed four profitable quarters in 2002 on a pro-forma basis. But if you look at the companys figures reported under generally accepted accounting principles, or GAAP, youll note that the strong results stemmed from a relatively high number of excluded expenses. Its like saying youre as handsome as Mel Gibson, except for the nose, eyes and mouth. In addition to a $2.5 million litigation charge taken in the first quarter, for instance, the pro-forma figures ignore amortization of intangible assets and acquisition-related costs. GAAP is GAAP and pro-forma is pro-forma. Were not deceiving anybody, weve always had them both out there. Were a bunch of good guys doing a decent job, Ronning, the CEO, said. To get a fair view of a companys performance, under GAAP rules an accountant must line up the costs of things like customer lists and trade names with the revenues that they generate. When those costs are removed in a pro-forma statement, investors are left with a muddled understanding of whats going on. When a company grows by acquisition, the strategy of excluding acquisition costs from earnings as a non-recurring item in the pro-forma statement is less than forthright. Overall, exclusions ranged from 26% to 750% of GAAP earnings over the trailing four quarters, according to Camelback calculations, underscoring the degree to which pro-forma earnings grossly exaggerate Digital Rivers newfound profitability. Thats absolutely true, said Ronning. But thats why we provide pro-forma and GAAP results. Additionally, although Digital Rivers claims 35% revenue growth in 2002, the company's financial-statement shows that much of that figure resulted from an accounting treatment called purchase-method consolidation. Because accounting rules mandate that two merged companies consolidate their books as of the acquisition date, Digital Rivers reported revenue growth appears more impressive than it really is. Its as if a baseball team added a new star player in mid-season, then reported a win-loss record that presumed the player was with them all year. When revenues are adjusted to reflect the organic results that would have been reported had consolidation occurred at the beginning of the period, according to Camelbacks analysis, Digital Rivers revenue growth is revealed to be a modest 8%. I dont think thats relevant at all, said Ronning. More trouble downstream? Normally when a company cuts expenses, its a good thing. But sometimes its cause for concern. Digital Rivers advertising expense has plunged in the past two years: down 7.5% in 2001, and then down 80.2% last year to amount to just 0.5% of revenues. While such parsimony makes sense in a difficult economy, Camelback points out that the earnings boost generated by the advertising cut could come at the expense of future revenues. Its the equivalent of a farmer cutting down on fertilizer to save money; it might help cash flow now, but those plants ultimately need nourishment. Digital River also faces several legal issues that could drain company coffers. Yet the company has not established any balance-sheet reserves in line with the recent litigation-related charge. In one dispute, Digital River executives and the underwriters of its 1998 initial public offering were named as defendants in several 2001 shareholder lawsuits. These suits, which were consolidated with similar cases involving other IPOs, complain that Digital River violated securities law by failing to disclose that its stock underwriters received kickbacks from individual investors. And theres one more thing: Digital River replaced troubled auditor Arthur Andersen with Ernst & Young during 2002. Unlike many of Andersens former clients, however, Digital River did not ask its new accountants to take a second look at its 2000 and 2001 financial results. Given the demonstrated shortcomings of its former auditors methodology, Camelback warns, Digital Rivers decision to go without a comprehensive re-audit of prior-year statements appears unwise. We didnt think it was necessary, and neither did E&Y, said Ronning. How many companies have spent the money for a complete re-audit do you know how expensive that is? The bottom line is that Digital River faces a large market but also numerous serious challenges that may not be fully discounted in the stock price. Yet shares have gone parabolic in the past month and a half, rising from $11 to nearly $19. If its purported earnings growth turns out to be sustainable, great; otherwise, a return at least to the $11-$12 area is a real possibility. Ronning himself proved a shrewd buyer of his own stock, purchasing almost $1 million worth last year at this time when it was at $4.94. There have been no insider purchases since, only numerous sales at around $14 in November. The market may elect to forget about valuation once again if it decides to make a new run at Nasdaq 2,000. But if balance-sheet and income-statement questions return to view, stocks with the most to lose are the ones of whom the most is erroneously expected. Then companies such as Trans World have a fighting chance, and companies like Digital River could in for a real dogfight. Fine Print I'll be speaking at the Money Show at the Bally's/Paris Resorts convention center in Las Vegas today at 11 a.m. and 6 p.m. Come on by if you're in town. ... Supermodels was named a finalist in the Gerald Loeb Awards for Distinguished Financial Journalism in the online/newswire, category, a nice honor. Winners will be announced June 30. ... Several readers wrote in to object to my description of Aron Ralston, the hiker who cut off his arm to save his life. Last week, in "15 gritty survivors worth the gamble," I called him "the ultimate survivor, the self-sufficient, super-rational adventurer prepared to adapt to any outrageous turn of fortune. ... What could be more emblematic of the path taken by public companies in the past few years -- and particularly the smaller ones with fewer resources?" Wrote Bill Sizer, of Nashville, Tenn: "Ralston is a very brave man. He is also a reckless adventurer who takes great risks for no other reason than to show that he can. He has received his reward---no arm. was it worth it? Perhaps to him. But he has actually done nothing of any benefit to anybody. The rewards of gambling on your stock picks may not be as drastic, but risk taking in the market for the fun of it is expensive." Said Dr. Harvey Rhoads: "One might also add stupid to the list of adjectives to describe MR. Ralston." ... The one-week results of the 15 stocks has been decent: They're up 3.5% as a group, and nine of the 15 have posted gains. Best of the bunch have been Manugistics Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund was not long or short any stocks mentioned in this column, but positions can change at any time. | |||||||||||||||
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