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Top Stories: Short Stories: SmarTalk's Travails
By Alex Berenson
Staff Reporter
4/2/98 7:26 PM ET
For months, SmarTalk (SMTK:Nasdaq) has been a classic Wile E. Coyote
stock, spinning its legs high above the canyon of an inevitable earnings
preannouncement and hoping that blind determination will take it across.
On Wednesday, SmarTalk, a Los Angeles-based company in the highly
competitive business of selling prepaid long-distance phone cards, opened its
eyes -- and promptly plunged 28%. But short-sellers, who have bet heavily in
recent months against SmarTalk because of its aggressive accounting,
nonexistent earnings and muddled business plan, say SmarTalk's drop isn't over
yet.
For the shorts, Wednesday's announcement was as predictable as it was ugly.
After the close of trading, the company told investors that it would lose about 5
cents per share in the just-completed first quarter of 1998, instead of earning the
nickel that analysts expected. Worse, SmarTalk said first-quarter revenues would
come in at only $40 million, 25% less than the $55 million that analysts forecast.
Investors reacted predictably. In trading Thursday, SmarTalk was down 8 11/16 at
22 7/16, cutting almost $200 million off the company's market capitalization. Still,
the shorts, who likely made more than $50 million Thursday, are hardly rushing to
cover their positions, which totaled roughly 30% of the company's outstanding
shares as of mid-March. Most say Wednesday's announcement is only the
beginning of the company's problems, and with SmarTalk up from less than 10 a
year ago to an all-time high of 36 last month, they think the company has quite a
bit further to fall.
"I would expect more disappointments before I would expect any good news,"
says a short-seller at a Midwestern money manager. "It's going to go down from
here." His price target for the company: $10.
Professional bears say SmarTalk has just about everything they look for in an
overvalued company. Its accounting practices are exceptionally aggressive,
enabling the company to report positive earnings from operations in 1997, even
though it had negative cash flow and took a huge one-time charge. Its apparently
strong growth rates come mainly from acquisitions of other companies with weak
balance sheets, not internal growth. Its officers and directors have sold tens of
millions of dollars of stock in the last few months.
Finally, SmarTalk's business plan is fundamentally flawed, the bears say. The
company, the only major publicly traded pure play in prepaid phone cards, has
tried to move the market upmarket, from people who simply can't afford a
telephone -- or don't want their calls traced -- to small-business owners and
travelers who find the cards a cheaper and more convenient alternative to
traditional calling cards offered by long-distance companies. To that end,
SmarTalk sells its cards office-supply stores, supermarkets, and the U.S. Post
Office in addition to convenience stores and check cashers.
Sounds good, but there are two problems with the company's strategy, according
to the shorts.
First, the plan leaves SmarTalk caught between much bigger companies. It buys
telephone time from giants like AT&T (T:NYSE), which provides its own prepaid
cards, so, in a sense, it's competing with its suppliers. Meanwhile, the huge
retailers who sell SmarTalk's cards to consumers won't hesitate to squeeze
SmarTalk to cut its wholesale prices, and to replace the company's cards with
other prepaid phone cards if SmarTalk refuses to cooperate.
Second, middle-income consumers and small businesses just don't seem
interested in buying prepaid long distance, which remains far more expensive
than traditional long-distance service, the shorts say. "These things are generally
pretty slow sellers at mass retailers. They're generally selling only one card a
day... No one goes into a mass merchant to buy a phone card," says a New York
short-seller who calls SmarTalk's valuation "absurd."
Still, the bulls haven't given up yet. While none of the analysts at the three major
brokerage houses who cover SmarTalk would return repeated calls for comment
for this story, all three published research notes Thursday reiterating their buy
recommendations on the stock -- even as they sharply cut earnings and revenue
estimates for SmarTalk for 1998.
Salomon Smith Barney, Donaldson Lufkin & Jenrette and Credit Suisse
First Boston lowered estimates for the year from an average of $1.28 per share to
79 cents, while revenue estimates plunged from $340 million to $260 million. But
all three companies said SmarTalk's core business remains strong and that the
first quarter's shortfall came mainly because the company didn't expand its
selling channels as quickly as they expected. "Underlying strength in [the] core
retail business is as good as ever," Salomon analyst Jack Grubman wrote.
Salomon, DLJ and CSFB were the lead underwriters in SmarTalk's 1996 initial
public offering.
A research analyst who specializes in searching for accounting improprieties and
whose work is often used by short-sellers says SmarTalk's lack of deferred
revenue growth proves the company's core business isn't growing. The company
records "deferred revenue" as a liability on its balance sheet after shipping its
cards to retailers, or after a consumer recharges a card by putting more minutes
on it. The revenue is considered a liability because SmarTalk has received cash,
but hasn't yet performed a service.
As a result, deferred revenue provides the most direct proxy for the growth of
SmarTalk's core business -- selling minutes on its cards. In 1997, SmarTalk's
deferred revenue soared from $2.7 million to $40 million, mainly because the
company grew as it acquired competitors. But in the first quarter of 1998, deferred
revenue remained flat at $40 million, company officials said on a conference call
Thursday.
That doesn't compute, the analyst says. If SmarTalk's business is growing,
"deferred revenue must grow."
But the analyst says SmarTalk's problems run deeper than simply a lack of
growth. The company's accounting is very aggressive, the analyst says, noting
that SmarTalk capitalizes its marketing expenses and amortizing over time,
instead of accounting for marketing expenses as a cost in the quarter in which it
spends the money.
That gimmick, along with other accounting tricks, enabled SmarTalk to report
income from operations of around $2 million for 1997, even though its cash flow
from operations was negative $9 million, the analyst says. "It's extremely ironic
and unlikely that a healthy prepaid business would generate negative cash flow.
That's just oxymoronic."
SmarTalk referred our inquiries to a conference call Thursday morning. During that
call, SmartTalk management, which has sold some 1.4 million shares of
company stock since November, promised better results. "This is fundamentally
a great business," SmarTalk President Jeff Lindauer said. "There's a very
credible, viable transaction space in the market for transaction-based
communications products...I think we're going to hit the cover off the ball."
For the shorts, he already has.
To be a candidate for Short Stories, a stock must be among the top 100 shorts
based on the ratio of total short interest to total shares outstanding, or be one of
the top 25 shorts based on the "days to cover" ratio, total short interest divided
by average daily volume. Special thanks to Michael Long of Rockbridge
Research, the publisher of Short ALERT, for research assistance. For a primer
on shorting, click here. If you have comments, please send them to Alex
Berenson. |
