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<DAILY TROUBLE>
Friday, June 25, 1999

Executone Information Systems
(Nasdaq: ELOT)
Phone: 203-876-7600
Website: www.executone.com
Price (6/24/99): $3 1/16

HOW DID IT FIND TROUBLE?

You pick a number, you take your chances.

On March 29, Executone's board said it planned to sell the company's core telephone and healthcare businesses to a management group for around $70 million -- and change the firm's name to eLottery. This in honor of the firm's money-losing subsidiary, which has never generated any revenues. Executone would suddenly become a cash-rich Internet commerce pure-play.

Traders loved the news, quickly bidding up the stock from $2 13/16 to an intraday high of $12 just 12 market sessions later. The last flourish came on word that eLottery president Michael Yacenda would appear on CNBC's Power Lunch just prior to the ticker change on April 19.

Since that lucky streak, though, the numbers have been all bad for Executone shareowners. Of course, it didn't help that the Internet sector has suffered a massive two-month sell-off, punishing the more speculative names the most. Moreover, talk in Washington of regulating online gambling (though not state lotteries) added to the gloomy backdrop.

So this multiple Double quickly turned into Trouble -- but ain't that just like the lottery.

BUSINESS DESCRIPTION

Based in Milford, Connecticut, Executone Information Systems develops and markets voice and data communications and information systems. These include voice mail systems, call center systems, and healthcare communications and workflow management systems.

This core business reported $133.5 million in FY98 revenues, down from $156.4 million in FY97. First quarter FY99 revenues dipped 6% to $31.7 million.

A management group led by Chair/CEO Stanley Kabala has offered "in the range of $70 million" for this core business. Shareowners have not yet voted on the deal, which apparently has not been finalized. But the public company will keep the cash, equal to about $1.11 per share.

The company's future is tied to eLottery (www.elottery.com), which aims to become a Web-based retailer of lottery tickets and related merchandise, in part by striking alliances with state lotteries. Its system basically will allow you to buy lottery tickets at home via your PC or telephone. Its technology can confine sales within certain states or countries.

The company has some experience in running online lotteries, having processed some 10 million online ticket sales and transactions. In December 1995 it acquired UniStar Entertainment, which developed the National Indian Lottery (NIL) for the Coeur d'Alene Tribe of Idaho. It added a weekly Internet-accessible lottery in January 1998. Last December, however, a federal court found that the NIL was not authorized under the Indian Gaming Regulatory Act of 1988.

So the NIL was shut down permanently, leading eLottery to write down to zero some $12.9 million in net intangible assets and $11.2 million in advances to NIL. Other one-time expenses were also incurred to shutter these operations. These costs figure into the $30 million eLottery says it has spent to develop its technology platform. eLottery was supposed to take 30% of the NIL's profits. Since the lottery was never profitable, eLottery never generated any revenues from the venture.

GTECH (NYSE: GTK), Powerhouse Technologies (Nasdaq: PWRH) (formerly Video Lottery Technologies), and Scientific Games Holdings (NYSE: SG) are the three major lottery services companies in the U.S. The first two have announced plans to create Internet-based lottery systems.

On April 14, the company announced that its preferred shareowners (the former owners of Unistar Gaming) had agreed to convert their holdings into 13 million shares of common stock, giving them a 21% stake in the company. That gave Executone "approximately 63 million" shares outstanding.

FINANCIAL FACTS

Income Statement*
12-month sales: $131.3 million
12-month income: ($37.4 million)
12-month EPS: ($0.75)
Profit Margins: N/A
Market Cap: $192.9 million
(*As of Q1 FY99. The relevant period of FY98 included a $25.5 million asset impairment charge, $9 million in special charges, and a one-time gain of $5.3 million.)

Balance Sheet
Cash: $0.9 million
Current Assets: $53.4 million
Current Liabilities: $34.5 million
Long-term Debt: $24.9 million

Ratios
Price-to-earnings: N/A
Price-to-sales: 1.5

HOW COULD YOU HAVE SEEN IT COMING?

The company's board seemed to agree that the main business is worth around $70 million in cash (plus, apparently, the assumption of Executone's existing debt). So an investor could mentally sell that business and think of the company as eLottery and a pile of cash.

Although the global lottery market is said to run to $110 billion annually, an investor needed to approach Executone with some skepticism. Unlike its much larger competitors, eLottery had never generated revenues much less turned a profit. Plus, broad experience and government connections count for a lot in the lottery market, and eLottery didn't have much to bring to the table in that area.

At its peak, though, Executone was being valued at $756 million before backing out its cash. That was astonishing in itself but even more astonishing when you look at market titan GTECH, which has recently sported an enterprise value of about 1.3x its nearly $1 billion in highly profitable annual sales.

Add in the circumstances surrounding Executone's rise -- Internet mania, executive's appearance on CNBC, snazzy ELOT ticker symbol -- and this stock should have looked like an attractive short for those who don't mind living a bit on the edge.

WHERE TO FROM HERE?

The National Gambling Impact Study Commission recently issued a bipartisan Congressional report that found that 15 million Americans are problem gamblers. The Internet isn't helping matters, as online gambling is expected to rise from perhaps $600 million annually to $3 billion by 2002, so Congressional action on this front is likely.

A bill designed to ban many forms of Internet gambling was introduced last year by Senator Jon Kyl (R-Ariz.) and approved in a 90-10 Senate vote. The Senate Judiciary Committee recently passed a watered-down version of this same bill by a 16-1 vote. State lotteries, however, would be exempted under the Kyl bill. So increased federal regulation of online gambling doesn't appear to pose a challenge to eLottery at this point.

eLottery has said that the average customer spent 4.1 hours a month at its NIL website, with the best customers lingering for 6 to 8 hours. The company's current demonstration lottery site (www.elotteryworld.com) will offer games and other interactive elements to keep consumers coming back for more and staying longer.

On May 12, Executone announced a strategic partnership with Autotote Corp. (AMEX: TTE) to jointly market eLottery's Web system to government customers. eLottery also licensed its instant ticker gaming system to Autotote. According to new eLottery chairman Robert Berman, the deal "affirms our belief that our Web-based lottery ticket retailing for governmental lotteries is complementary, not competitive, with traditional lottery companies such as Autotote."

More recently, former GTECH executive Rick Calinsky joined the company as sales director. Because attracting customers will likely involve attracting well-connected executives from the other leading lottery firms, more such personnel additions are probably in the cards.

For now, though, an Executone stub is basically a long-term call option on eLottery's ability to cash in someday on Web lottery sales. The company's online experience, though limited, may be enough to give it a competitive advantage in this niche. And assuming the core business gets sold off as planned, eLottery should also have plenty of cash to make a go of it.

Still, this is a speculation on America becoming wired for speculation, real speculation -- not just day trading, where the odds of success are actually considerably better than with the lottery. Some Fools may have an ethical problem with a company like this. It's just hard to cheer for a company whose success will arguably bring great harm to people.

In any case, speculators should take note that these shares traded down to just 69 cents per share last fall. So while well off their high, they still aren't exactly cheap compared to where they've been in last year.

-- Louis Corrigan (TMFSeymor@aol.com)

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