C-Cube Microsystems (CUBE:Nasdaq) is a dog with fleas, a third-rate semiconductor maker whose biggest business is the brutally competitive game of selling cut-rate video disc players to China. The company's stock has gone from 70 to 20 in two years, and it's not done falling yet.
No, no, wait a minute.
C-Cube is just ahead of its time. The company pioneered digital compression of video images, and its newest generation of digital video discs will replace both VCRs and CD-ROMs, helping to speed the convergence of computers with televisions. And C-Cube's other businesses are only getting bigger.
"Welcome to the holy war," says Dan Scovel, a C-Cube bull and analyst at Fahnestock, a regional investment bank based in New York. "You'd be hard-pressed to find any stock that [generates] stronger opinions in the investment community, be they positive or negative."
Well-known short-sellers, including Rocker Partners and Tiger Management, have already made tens of millions of dollars on C-Cube by correctly betting that the company's stock would crater. But those profits haven't made the shorts, who were publicly slammed by C-Cube President Alex Balkanski last year, any more forgiving. C-Cube's problems will only get worse in 1998, as its margins shrink and its hopes for new business dry up, they say.
Short-Sellers See More Problems Ahead
"The fundamentals in C-Cube in the last 18 months have just steadily deteriorated. Their business has just really imploded ... I think the stock's worth $6 to $8 on a sunny day," says Rocker's Marc Cohodes. "These guys do not deserve the benefit of the doubt."
Meanwhile, sell-side analysts, many of whom stayed bullish on C-Cube as its stock tumbled, aren't ready to give up hope. They argue the company learned from its stumbles in 1997, and still has the leading technology for a new generation of digital video products for the consumer, PC and broadcasting markets.
"They have a very good chance," says BancAmerica Robertson Stephens analyst Elias Moosa, another C-Cube bull. "It's up to them to fail, because they have the tools to succeed."
"The more I look at the company, the more layers I peel back, [the more] I find good people in the company," says Scovel. "There's a lot of stuff here, and these guys are making a real viable business." (Robertson Stephens underwrote a C-Cube stock offering in 1995. Fahnestock has no investment banking relationship with the company.)
C-Cube's Leadership in Video CDs
No one disputes that C-Cube has been one of the leaders in the tricky business of digitizing moving images. While the now familiar compact disc has been around for more than 15 years, "digital video discs," which are to videotapes what CDs are to cassettes, have proven much more difficult to engineer, largely because producing movie-quality images requires vast amounts of data.
So unless you're a consumer electronics buff, it may surprise you to know that so-called video CDs, which are a primitive version of digital video discs, have been available for more than three years.
Where? China. Because video CDs don't have recording capabilities and are only about 75 minutes long, they've been unable to displace VCRs in the U.S. or other rich nations. But they've proven a huge hit in China, where they're widely used to show pornography and illegally copied U.S. movies. C-Cube sold 11 million video CD players in China last year, spokesman Nick Kormeluk says.
After a trip to China a year ago to see if the potential for video CDs matched C-Cube's claims, one person knowledgeable about C-Cube came away astonished by the company's success. "It was a perfect play for that market, and the technology was there and they got locals to build that thing. ... It was unbelievable."
The popularity of video CD sent C-Cube's revenues and profits soaring. The company's revenues went from $45 million in 1994 to $320 million in 1996, while profits increased more than tenfold, from 16 cents per share in 1994 to $1.63 per share two years later, excluding one-time charges. C-Cube stock followed, rising from under 8 in early 1995 to its all-time high of 73 1/2 in February 1996.
But short-sellers rapidly took aim at C-Cube, predicting that the company's ultra-high margins in China couldn't continue. In mature markets like the U.S., consumer electronics is a cutthroat business, with low margins, intense competition and steadily falling prices. For its first year in China, C-Cube didn't face those problems. The reason was simple; the company had a monopoly.
That happy state of affairs changed in late 1996, when ESS Technologies (ESST:Nasdaq) entered China with its own video CD player. Prices plunged "viciously" as the companies fought for consumers, Moosa says.
The shorts weren't oblivious to C-Cube's problems. Our own Herb Greenberg, then writing in The San Francisco Chronicle, and Fortune, repeatedly warned investors that the price war in China would crush C-Cube's profits.
The company's stock slipped from 50 in October 1996 to half that by February 1997, as the short position in C-Cube stock soared. By spring, the short position topped 11 million shares -- an astonishing one-third of C-Cube's total shares outstanding. A furious Balkanski fought back, accusing Rocker and Tiger of "rumor-mongering" in an interview with Bloomberg News.
Unfortunately for C-Cube, the rumors were right. On May 20, 1997, C-Cube said it would earn only 20 to 25 cents in the second quarter, not the 40 cents analysts predicted, because of lower-than-expected sales and heavy price competition in China. The company's stock dropped 22%, to 19 7/8, on the day of the disclosure.
Cohodes says he's still angry that Balkanski questioned his integrity. "This guy should be censored by some authority for falsely promoting horse**** to people... I don't call other people names, and I don't appreciate it in return," the short-seller says. He adds, "I'm a whole lot less worked up about this thing than I used to be." (C-Cube did not make senior executives available for comment.)
Banking on Digital Video
After the debacle in May, C-Cube stock recovered during the fall, hitting 35. But the rally proved short-lived, and the stock has settled into a trading range in the high teens and low 20s so far this year. It was trading Friday at 18 7/8, down 1/4.
Short interest in the company has declined along with its stock. Still, about one-sixth of C-Cube's 36 million shares have been shorted, putting the company near the top of the list of heavily shorted companies. And the bulls and bears are as divided as ever about the company's prospects.
"Digital video disc is going to revolutionize the video market, and it will do to the videotape what the music CD did to the audiotape," says Robert Gintel, portfolio manager of the $200 million Gintel fund, which ranks in the top 10% of all U.S. equity funds for five-year performance.
"It's the one stock we've lost money in," says Gintel, whose fund owns 200,000 shares of C-Cube. But he says he continues to like the company because he thinks that digital video will generate significant consumer interest as soon as C-Cube rolls out a disc player that can record as well as play videos, a development he expects by late 1998 or 1999.
"I own a DVD player. I've installed it," Gintel says. "You get amazing clarity of picture and sound reproduction."
Indeed, digital video offers some significant advantages over videotape. For example, it allows studios to include two versions of the same movie on a single disc, so parents can watch an R-rated cut of a movie while their kids see the PG version. And a two-sided disc will have enough capacity to fit even the three-hour movie Titanic on a single disk.
James Reynolds, an analyst at Wedbush Securities in Los Angeles, says even if digital video does take off, C-Cube may not profit. By the time consumers are ready for the new technology, big electronics companies will be making their own chips, and C-Cube will face the same intense price competition in the digital video disc market as it has in the video CD market, the analyst says.
"They had hoped to be out there and win a lot of business on the consumer electronics side, but now it seems that the manufacturers are developing their own [digital video] chips. ... All these markets are slipping away. It's almost like the stars have been unfavorable," Reynolds says. (Wedbush has no investment banking relationship with C-Cube.)
But with digital video slow to build, C-Cube remains heavily dependent on the Chinese video CD business, which accounted for almost half its revenues in the fourth quarter of 1997, according to the company. With prices continuing to drop and the risk that China's economy will suffer the same problems that have hit the rest of Asia, video CDs are "not a market with a long and prosperous future," Moosa admits.
Earnings Expectations Keep Drooping
As a result, analysts expect the company's earnings to drop in 1998 for the second straight year. C-Cube will make $1.10 per share in 1998, down from $1.15 in 1997 and $1.63 two years ago, according to First Call. (In a measure of how far expectations have fallen for C-Cube, the current estimate for 1998 earnings is less than half the $2.90 per share that analysts once expected the company would make this year.)
But Scovel says C-Cube has at least one more card to play. He notes that besides making the chips used in consumer products to decode digital signals, the company also designs the much more complex semiconductors used to encode the signals before they're transmitted. Buyers for the encoding technology include television stations that will need to convert from analog to digital transmission over the next few years, as well as satellite broadcasters like Echostar (DISH:Nasdaq).
Reynolds says that the encoding business is C-Cube's best chance to prosper long-term. "I'm hoping that in the second half of the year, some big gains come out of the systems business," he says. "That's a potentially very large market. ... Those [satellite] broadcast centers go for $150 million a pop -- if they could start cracking parts of that, they could have a real business."
But Cohodes notes that C-Cube is competing with several much larger competitors, including IBM (IBM:NYSE), SGS-Thomson (STM:NYSE) and LSI Logic (LSI:NYSE), in the encoding market. At best, that part of the company is worth $300 million, and since the rest of C-Cube is essentially worthless, the company isn't worth more than $8 per share, he says. |
