It's long but it's in there
Scam or Reality?
Peter Lynch, Warren Buffett, and most other successful investors insist that one of the best ways to lose money in the stock market is to invest in technology stocks you don't understand. In the midst of investor fads, this axiom may seem like merely quaint folk wisdom. For nearly a year, anything even vaguely connected to the Internet soared, and speculators savvy enough to ride the wave have made some fast and easy money.
But woe to those who believe the hype even if they can't understand the technology. When the wave crashes, your portfolio may well be nothing but a shark's next meal.
Investors in Diana Corporation (NYSE: DNA) know the feeling. The stock rode a wave of manic momentum buying from a 52-week low of around $10 a share last fall to an all-time high of $114 late this past spring. [See Diana's performance for the year: DNA Quotes: Weekly for 1 year.]
This stock went tidal on news that Diana, which still derives most of its revenue from distributing meat and fish, had turned itself into a provider of supposedly cutting-edge data switching devices.
But then the frenzied buying was over, and within months---hear the Dick Dale surf guitar?---wipeout. The stock has been treading water between the low 20s and mid 40s ever since.
Even at those prices, though, Diana is still nothing but a pipe dream according to New York investment advisors and highly visible short-sellers Asensio & Company. An active participant on several stock boards in THE MOTLEY FOOL, company president Manuel Asensio has issued a number of press releases denouncing Diana as nothing but a fraud run by scam artists. The stock isn't worth more than $5 a share, he says.
Asensio is hardly an unbiased source of information. With an undisclosed but presumably still significant short position in Diana, he has an interest in spreading negative news that will drive the stock price down. Some would even say he's willing to make up negative news. And many individuals who've crossed his path find him pompous, self-promotional, and generally annoying.
On the other hand, it's still relatively unusual for short-sellers to launch public campaigns against a company the way Asensio has. While investors may not like short-sellers, carefully considering the shorts' arguments, whatever their merits, can often be a constructive exercise. For one thing, it often becomes easier to dismiss a company's critics once you know what they really think. For another, shorts may open one's eyes to an ill-considered investment.
Last Tuesday, October 15th, Diana stockholders were encouraged to question what they do and don't understand about the company's prospects when Asensio & Company issued a strong sell recommendation in the form of what appeared to be a devastating 16-page report on the company's much-touted Internet technology. Asensio put out a press release summarizing the findings and took the unusual step of posting the report on the Web (available at http//:www.popdata.com/asensio).
After conducting "an exhaustive technical software and hardware evaluation" of the company's products, Asensio concluded that Diana's "performance claims, which form the basis for any anticipated growth, are wholly false and incorrect." The company's products are "completely uncompetitive" and "it is technically and economically impossible to attempt their resurrection."
The report concluded that "the Company's performance will continue to deteriorate for the foreseeable future. We see no reason for any investor, particularly investors with a fiduciary duty, to purchase or hold this security."
Asensio's report hit the wires in the morning, before the market opened. Within the first hour, Diana's shares were trending down from $32 to a low of $28.75. The company then asked the New York Stock Exchange to halt trading in the issue pending a news release. Five hours later, the wire services picked up Diana's response to Asensio.
Without specifically addressing any of Asensio's charges, James J. Fiedler, Chairman and CEO of Sattel Communications (the Diana subisidiary that sells the switching technology) came out swinging.
"[Asensio's] purported 'news release' is false and misleading. This apparent manipulative style of 'news' releases is obviously only aimed at attempting to put pressure on the stock price by an acknowledged short seller. I believe that our customers who have employed our products would be greatly surprised to learn that features and capabilities that they use every day somehow do not exist, as alleged by the short seller."
The company's press release also indicated that Sattel was "in possession of a letter which states in part as follows: 'This letter provides written documentation regarding a request offered to me by a Manuel Asensio, representing Asensio & Co., New York, New York in September of this year, to perform a negatively biased engineering analysis on the Sattel products and organization for a fee of $5,000 dollars plus a percentage of the profits made short-selling Diana Corp. stock...' The analyst refused, citing the untruthfulness of the premise."
Finally, Fiedler said that Sattel has recently hired 12 new salespeople, additional R&D personnel, and a new CFO, suggesting the company was indeed growing. In a phone interview with ROGUE, Fiedler said that Sattel now has 20 fulltime employees working on R&D with 8-10 fulltime consultants at any point in time plus four other companies doing subcontract work. All total, he estimated R&D man-hours per month were in the high 40s. "We're probably spending 25-30% of our revenue on R&D," he said.
In the press release, Fiedler also said that Sattel expects to report about $4 million in revenues with a modest profit (instead of a forecasted loss) for the quarter ended September 30, 1996. When the stock re-opened about ten minutes before the close, it quickly rallied to end up $3.25 to $35.75.
Diana short-sellers were dismayed by these developments. They contended that Asensio had contracted an expert consultant with special insight into the relevant technical issues. In their view, Fiedler's response was an attempt to distract investors from the substance of Asensio's charges by refocusing attention on Asensio's inarguably self-serving motives.
Several shorts charged that Diana misrepresented the material nature of the news release in order to stop the bleeding in the stock. Asensio simply said that "the company's representations to the New York Stock Exchange were false and fraudulent." The shorts argued that the company was simply trying to buy time to work up a response and line up buyers for the stock once it re-opened.
"Absolutely false," said Fiedler. "I can tell you that people called us and asked what's going on, and we said we're preparing a response. Period. We didn't say what it was going to say. ... We didn't go out and solicit buyers for the stock."
Fiedler said he believed the halt was appropriate due to the "blatant falsehoods" in Asensio's report and the confusion in the market that it created. And as for the timing of the re-open, Fiedler said the company issued its press release at 2:19 pm, but that the NYSE wouldn't open the stock until the Dow Jones News Service picked it up, which took more than an hour. Fiedler said they probably would have just re-opened the stock the next day if they had known the trading would re-commence with only a few minutes left in the trading day.
For the last ten days, Asensio and Fiedler have been trading shots at each other. Asensio said his attorneys have served both Diana and Sattel with the demand that they produce the letter mentioned in their press release. In his own press release, Asensio affirmed that "Asensio & Company have never offered any cash, any fee, or any percentage of any trading profits to any analyst, advisor, or consultant for any negatively biased or untruthful report on the Diana Corp. or on any other company."
Fiedler declined to make the letter public, but in a follow-up news release this past Monday, Sattel indicated that they had received a second letter from a different consultant whom Asensio allegedly approached with a similar offer to produce a negative report on Sattel's technology. Fiedler said that the first letter came from an outside consultant who "has done work for us in the past" but that the second letter came from a consultant with no such ties to the company. Sattel has turned both letters over to their counsel, who are expected to pursue the matter with the proper authorities, presumably the SEC.
This public battle is great theater, but so much smoke does not necessarily guarantee a fire. On the other hand, Asensio is not the only party to express skepticism concerning Diana's prospects. Numerous reports in the financial media have puzzled over the company's surprising re-fashioning of itself from meat and fish distributor to Internet highflyer.
A Real Transformation?
Indeed, in a July article, ROGUE even examined claims made by some investors that Diana was an old-fashioned Wall Street promotion orchestrated by leading New York City hedge funds, some of which have recently been selling or registering to sell huge chunks of Diana (see the newly amended S3-A showing that Arthur and Joseph Samberg of New York's Dawson-Samberg, among others, plan to liquidate their holdings). The checkered histories of Diana CEO and chairman Richard Y. Fisher and president Donald E. Runge (who sold a large block of shares this summer) suggest that anything may be possible.
[Check out our earlier look at Diana: 7/23: When Should Investors Worry?.]
With 5.3 million fully diluted shares outstanding and a recent stock price of around $30 a share, Diana's market cap is $159 million. Yet the shorts make a strong case that neither current nor foreseeable earnings can justify this share price. The company lost $0.17 a share in 1995 and $0.76 in 1996. Trailing 12-month earnings show a loss of $0.93 a share. Asensio estimates that Diana will lose $1.25 a share for fiscal 1997, ending in March.
On September 4th, Diana announced its unaudited first quarter results for fiscal 1997. Net sales increased to $87.2 million from $81.5 in the first quarter of 1996. However, the company reported a net loss of $1.3 million ($0.27 per share based on shares oustanding prior to the recent 5% stock dividend) compared with a loss of $0.4 million ($0.10) in the first quarter of 1996.
The heavier losses followed from reduced earnings by Diana's C&L Communications business and increased losses at the Atlanta Provision Company, the meat and fish distribution unit that Diana has been unsuccessfully trying to sell off for more than a year. This unprofitable unit accounts for 85% of the company's sales.
The key to Diana's future, however, is supposed to be Sattel Communications, the now wholly-owned subsidiary that's in the business of marketing telecommunications switches. The unit was formed in 1994 as a joint venture with Sattel Technologies Incorporated (STI). At that point, Diana was trading at $3.50 a share.
In the last year, STI has swapped its entire 50% interest in Sattel for shares of Diana. Diana's recently amended 10K indicates that STI just cashed out its last 4% of Sattel in exchange for 15,000 shares of Diana. The latest amended S3-A filed Monday October 21st, however, shows that STI has registered to sell all of its 330,000 shares.
While Diana's stock is trading on great expectations for Sattel, switch sales for the last quarter were only $840,000, $796,000 coming from the sale of two Digital Switching Systems (DSS switches) to California-based Internet service provider Concentric Network Corporation (CNC) and the remaining $44,000 from what Fiedler described as a "small upgrade to a previous customer."
For the fiscal second quarter ending in September, Sattel's projected $4 million in revenues also come mainly from sales to Concentric. According to Fiedler, Sattel sold five DSS higher-capacity switches to Concentric in the second quarter, with each costing about $600 thousand, he said. The two switches sold in the first quarter were upgraded (at a cost of about $200 thousand each) in the first weeks of October and should appear as revenues in the third quarter.
Still, this means that of Sattel's $4.8 million in projected revenues for the first six months of fiscal 1997, a total of seven switches sold to Concentric accounted for $3.8 million in sales. Fiedler said the additional $1 million in sales for the second quarter came from shipments of of 2-3 switches to perhaps two other customers. He said he did not know yet what sales had been booked in the second quarter versus the third and could not release the names of customers at this point.
These numbers, however, suggest the importance of Sattel's contract with Concentric. In July, Diana announced that it had finalized a deal whereby Concentric would purchase 21 DSS switches within the next 12 months. According to Concentric spokesperson Donna Laughlin, CNC is in the process of transforming its 214 points-of-presence (POPS) in the U.S. and Canada into 21 SuperPOPS by the end of calendar year 1997, and each of these SuperPOPS will include a Sattel switch.
Originally, investors speculated that 21 switches would amount to $42 million in sales for Sattel. But the company's switches can be purchased in configurations costing anywhere from $125,000 to $4 million according to spokesperson Tony Squeglia. Customers typically buy the basic switch and then add capacity over an extended period of time as their business grows. In that sense, the ultimate value of the switch sales depend a great deal on the market success of Sattel's customers.
Fiedler says that the Concentric switches may generate $2 million a piece "over a long term horizon, but certainly not right away." If CNC reaches the success level they're shooting for, "yeah, they could be worth that much. But that's over a life cycle" of the switch, which could be several years. Though Fiedler suspects that Concentric may eventually purchase more switches as their business grows, he says "there is no commitment from Concentric for more than 21" switches at this time.
Based on Fiedler's comments, the sales of switches to Concentric seem to be on a pace to generate only about $12.6 million over the next year or so. Moreover, Diana last week amended its 10K filing with the SEC to indicate that the Memorandum of Understanding between Sattel and CNC was "nonbinding."
The Concentric deal has sparked widespread skepticism since it at least appears to have been secured by a $5 million bridge loan from Diana, suggesting that Diana has essentially paid Concentric to accept the DSS switches and thus validate the company's technology.
In a phone interview, Asensio said that he believes Concentric agreed to the switch deal because Concentric was unable to pay its overhead expenses at the time.
"[Concentric] could not make their payroll. There was a company that was doing the financing, the financing had failed, they were cash flow negative with no money in the bank. And they were offered $5 million in return for a very soft promise possibly to buy a telephone switch. Now that's a deal that anyone would make, and that's the deal they made."
Yet Fiedler says that these were "two very separate transactions."
"We were looking at putting up a wholesale network to sell to smaller, regional ISPs. We'd done the evaluation. We knew how much capital it was going to cost. Concentric made the suggestion to us that rather than build our own network and probably spend 12 months to do it in terms of putting up sites and so on that they were in the process of going out to do a round of funding, and that if we wanted a participate in the funding that a) we would get a stake in Concentric and secondly we would have access to the Concentric network at a very favorable cost. The advantage was that their network was already up and running."
Sattel orginally planned to invest about $5 million along with its recently announced strategic partner StreamLogic also pumping in $5 million. But CNC's funding was oversubscribed, meaning they only needed $2.5 million from Sattel. But because of delays in reaching an agreement over the wholesale business and delays cause by the involvement of international investors, Concentric's fund-raising deal didn't close in June as expected. At that point, CNC came to Fiedler and asked for a $5 million secured loan to tide them over. As security, CNC offered Sattel common stock, interest on the loan, and warrants equal to 15% of the stock.
In August 1996, the loan plus interest was converted into 3,729,110 shares of CNC Series D Preferred Stock. In September, Sattel sold 1,838,235 shares of this stock to StreamLogic for $2.5 million. As Fiedler explained, "The money that I had lent them was converted to equity. I got my stock, I got my warrants."
The recently amended 10K states emphatically that the $5 million loan "was not a condition of the Memorandum of Understanding" regarding the sale of switches. In addition, it appears that Sattel's investment in Concentric was limited to $2.5 million which has since been converted into what Fiedler estimated was a 2-3% equity position in Concentric.
"The deal was actually a good deal in my opinion for two aspects," Fiedler said. The distribution arrangement will allow Sattel to save perhaps 12 months and require less capital than would have been the case if Sattel had constructed its own distribution network. Second, Fiedler believes Concentric is a sound investment due to the company's expansion plans and content deals with WebTV, Intuit, and Sega Genesis. "I have faith in their strategy. Unlike lot of ISPs, they are really concentrating on content."
But confusion over the switch sales and loan to Concentric justifiably raised questions about Sattel's prospects. And the fact that CNC still accounts for the overwhelming majority of Sattel's sales should leave investors somewhat uneasy.
This is especially true since Diana is working with Hambrecht & Quist on a restructuring that, according to Diana's Fisher, would "make Sattel Communications a 'pure play' by separating it from Diana's other subsidiaries."
Fiedler said, "We absolutely could miss by a week or two, but we're shooting for early November" for announcing the details of the restructuring." It probably wouldn't be effective for another 45 or 60 days" since the documents would need to pass SEC scrutiny and the deal would need to be approved by shareholders. According to public documents, however, there "can be no assurances that any such transaction will take place, nor can there be any assurances as to the timing or value of any such transaction."
Since Diana's Sattel subsidiary is clearly supposed to be the company's principal growth vehicle going forward, shorts and other critics have focused on that part of the business. Last week's report represents Asensio's most thorough attempt yet to discredit Sattel's technology and burst the Diana bubble once and for all. The report argues that, rather than offering any performance advantage over competitors, as Diana has claimed, Sattel's technology is dated and all but obsolete with essentially no sales potential and certainly nothing that would justify Diana's current market cap.
In this past Monday's press release, Fiedler said that the report clearly indicates that Asensio "has no understanding of our products, technologies, competitors, and markets, and that his decision to purposefully communicate inaccurate and misleading information does a grave disservice to our customers, our shareholders, and our employees. . . . [W]e suggest that Mr. Asensio ask the consultant that wrote the report for a refund."
[Check out a description of Asensio's report: 10/25: Asensio's Report and Sattel's detailed response: 10/25: Sattel's Response.]
If Asensio contends that Sattel's technology simply cannot do what the company says it does, Fiedler argues that Asensio simply doesn't understand what the technology is supposed to do, or the problems it is meant to solve. One obvious way of figuring out if the technology works would be to talk with Sattel's customers. But Concentric has refused to go into any detail about the switches, and discussions with other Sattel customers have offered a mixed picture.
The inter-exchange carrier Lightcom has operations in San Antonio, Texas and main offices in Washington, DC. Lightcom bought two Sattel DSS 3000 switches about a year ago and has helped beta test the company's recently announced adjunct processor platform that provides enhanced 800 number translations and time of day routing features, among others.
According to Julian Bart, director of operations for Lightcom, the Sattel switches have worked well. There were some software bugs with the adjunct processor platform early on that have been fixed by Sattel. Overall, he said the company was satisfied with the product. He also said Lightcom can and might expand the switches up to 10,000 subscriber lines and that the company plans to buy three more switches over the next five years. He would not reveal what Lightcom paid for the switches.
Bart is also an enthusiastic supporter of DataNet. He said he's discussed the product at length with Sattel's developer and engineer. "To me it's probably one of the most innovative products to come down the pike." He said Lightcom doesn't need it yet. "But there's no doubt about it, we will."
He also said Lightcom doesn't have SS7 capability at the moment but he expects they will at some point. "We have not ordered it yet. We're waiting until we get a little bit more network up and then we'll go with the SS7."
Datacom (DCI), an ANSI and local exchange carrier that provides tandeming and blocks of minutes primarily for corporate customers in Miami, purchased a DSS switch in September. (Fiedler could not confirm whether this purchase landed into the second quarter or not.) The company has four employees and reported sales last year of less than half a million dollars. The switch is believed to cost about half that much and was secured with a capital lease.
Company president Anthony Harper said, "We're very satisfied with the switch. We're very satisfied with the company's support, as well." He said the switch includes SS7 capabilities. Though he said that it is not a distributed switch, he also said the switch is easily updated because of built-in redundancies that allow changes to be made "while it's hot."
Harper said he chose the Sattel switch for price and because it was more scaleable and versatile. He said software upgrades can be expensive but that Sattel offered an attractive deal in this regard.
A third Sattel customer contacted was Jerry Hamilton, director of international technical operations of Rochester-based Frontier Communications. Hamilton purchased a DSS96 in December of 1995 to link up to a switch in Russia, an application that was very small and static and thus required simply the lowest cost solution. The switch cost less than $100,000.
The switch has "been fine. It definitely has its place," he said. But Hamilton suggested this the switch is most useful for smaller applications.
"Once I get above where I'm at now, it stops becoming effective for me because when I start getting into the larger applications, then the other manufacturers of true international gateway switching (Northern Telecom, Erickson, etc)" start looking more attractive. "You go ahead with high up-front costs because the feature sets offered with the switch offset trying to grow it on the smaller basis."
He also said that Sattel doesn't currently offer the kinds of international SS7 variants that he needs, so it's unlikely he'll be in the market for more switches from them. "A prime consideration is SS7, and I have to talk on several different flavors of SS7. I want to be able to accomodate other types of signaling as well. I can do that as long as it's not SS7. The SS7 on the Sattel switch has not been deployed, it's behind."
"I need a great deal of flexibility without having to wait," he said. "As I roll out new features and services, I have to have a device that I know will interface with the rest of my network. So I'm going to tend to go with the vendor who is already known to provide those applications."
He also said that while "you can just keep tying the frames together" to get up to 10,000 ports, "that's not necessarily a real efficient way to do it because you lose some of the capacity by tying it to the frame next to it."
Fiedler said that Hamilton is correct. "He's talking about C7, the international version of SS7. C7 has an international version almost for every country." Sattel doesn't have a Russian variant of C7 running, which would make it impossible for Frontier to use Sattel technology with its Russian customer.
Despite Sattel's thin customer base at the moment, Fiedler believes the company is poised for tremendous growth. "We're sure as hell not going to stay at $4 million" per quarter, he said. "We obviously believe that we're on a growth curve, or I wouldn't be here."
He said the that the $4.8 million in revenues expected for the first half of fiscal 1997 "isn't going to be a fifth of the revenue" for the year. "Are we going to do more than double next year? Well, if we do our job."
Asked if he could justify the $200 target price bandied about earlier this year by Hambrecht & Quist analyst Joe Noel, Fiedler made an attempt. Taking the second quarter run rate of $4 million, and considering that the company made a little money, "it looks like we have a lot of capability in terms of earnings per share."
"I leave it to the gods as to what PE ratio they put on this, or any company by the way." But he said a PE of 40-50 based on his expectations for earnings would land the stock in Noel's range. For fiscal 1997, Fiedler said he expected $25 million revenue "or more." For fiscal 1998, "I would be grossly disappointed if we doubled it. A good company on a roll should be able to triple it." He said the margins are running 25%, suggesting the company could do $4 or $5 dollars a share, or total earnings of about $20 -25 million for fiscal 1998.
"So if you did a hundred million in revenue, you'd be there, based upon the way they're doing PE. ... Will I step up and guarantee that? Hell no. Do I think that's outrageous? No."
Given such optimistic predictions from Sattel's CEO, it's somewhat difficult to account for the actions of STI, the company that sold Diana the switching technology. Though there are several steps in STI's agreements with Diana, STI appears to have sold its stake in the once jointly owned subsidiary for 330,000 shares of Diana, currently valued at around $10 million. What's even more interesting, the recently filed amended S3 shows STI registering all of these shares for sale.
ROGUE could not reach George M. Weischadle, Sattel board member and chairman, president, CEO and majority stockholder of STI. So it's hard to know when STI will actually sell these shares. But it's at least curious that STI seems anxious to unload its stake sooner rather than later.
According to Asensio, "It's up to market participants to correctly price capital assets. The people who provide research, who are in the market, who give advice to people, those are the people who set the prices for stocks. It's a fallacy to sit back and think that the NYSE or the SEC is going to police the market to such an extent that frauds like this will not be perpetrated on the market."
Of course, it's not at all clear that Diana is a fraud. If an investor believes Fiedler's comments and the rebuttals issued by Sattel in response to Asensio, there seems to be nothing in Asensio's charges that should give investors pause. On the other hand, there's very little earnings visibility for Sattel despite Fiedler's ambitious plans for growth. Discussions with Sattel's few customers offer a mixed picture.
But more speech ought to be better than less when it comes to making markets more efficient. Whatever the merits or faults of Asensio's report, publishing it on the Web at least gives all investors access to the shorts' main arguments even as it clearly serves Asensio's own financial interests. Still, those arguments should make Diana investors look more closely at whether they do indeed understand the business they've invested in.
At the very least, the report has triggered a series of detailed financial and technical disclosures from Diana and Sattel that clarify the Sattel's business. But the soap opera, no doubt, will continue.
-- Louis Corrigan (RgeSeymour), 10/25/96 |
