A Post Mortem on MicroStrategy (Fool on the Hill) March 22, 2000

An Investment Opinion

A Post Mortem on MicroStrategy

By Bill Mann (TMF Otter)
March 22, 2000

Over the last three weeks we have seen market volatility that has made the quaint notion of an efficient market look ridiculous. This is most notable with the high tech lynching of MicroStrategy (Nasdaq: MSTR), which went from $333 per share last week to just $72 yesterday. Put another way, MicroStrategy, went from a $23 billion market cap to one just over $5 billion, a loss of 79%. And several Biotech companies, among them Rule Breaker stock Celera (NYSE: CRA) have taken it on the chin with similar, or even greater, losses.

All of this feeds back into my thesis from two weeks ago that the market in its speculative state is an inefficient evaluator of the future value of companies. One of the companies I talked about in that article, Rambus (Nasdaq: RMBS), has since dropped more than 45%, then ran back up 33% on the heels of some positive remarks by analysts. None of this qualifies as news that affects the operations of the company.

All of these things lead me to reiterate a simple truth about stocks: If you don't know what you're buying and how they make money, your chance of making money over the long run is very small. Anyone who counted on momentum (an example) or technical analysis (another example) to determine that MicroStrategy, for example, had some run left in it, or whatever, has just lost a boatload of money. But one simple question, asked of the company's investor relations before the drop, would have turned up a palpable risk to investors' dollars.

I'm not writing this to mock MicroStrategy investors. Man, I've been there. I missed a sign the size of several small buildings when I elected to buy stock in Iridium in late 1998 and watched my investment wither up and blow away. What I'm seeking to do is use this event as a lesson. For those of you who lost money here, in biotech, in Iridium, wherever, if you lost money AND failed to recognize your mistake, then you have truly blown it. Because everyone makes mistakes in investing. Everyone. That's not failure. Failure is repeating the same mistake over again.

One of the greatest strategists of all time, Sun Tzu, wrote:

"Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win."

I have used this quote in several articles, because it serves as a wonderful reminder of the importance of research before you ever buy a stock. All too often each of us who spends any time on the Message Boards see a new investor who posts that he or she has bought a company's common stock and is only then seeking to learn about it. Wrong!

Many people bought into the premise of MicroStrategy, and had such faith in it that they gave it an earnings multiple in the thousands. But, MicroStrategy investors, did you know that the majority of the company's sales were based upon long-term service contracts? If you didn't, you shouldn't have bought the stock. If you did, then did you call Investor Relations and ask them how the revenues from these long-term contracts were being booked? No? Then you got exactly what you bargained for. You took a gamble without knowing where all of the risks to your investment were coming from.

And to those of you out there who are nodding your heads and thinking how stupid MicroStrategy investors were, how many of the companies you hold derive their revenues in the form of long-term contracts? Do you know how these revenues have been recorded? How confident are you that the accounting practices at the companies you hold are designed to protect your investment?

You see, according to the Financial Accounting Standards Board (FASB), MicroStrategy did nothing wrong. Do you hear me, all you attorneys filing class action suits "on behalf of investors"? They did nothing illegal. What they did do was use an accepted accounting premise and book their long-term contracts as current revenues. For example, in January, Exchange Applications (Nasdaq: EXAP) signed a $65 million long-term deal with MicroStrategy, $14 million of which MicroStrategy booked as revenues in the quarter that ended three days before the deal was signed. Its legal, but it is very aggressive, since it inflates current sales numbers. Even better, because the services for these sales do not have to be provided for until well into the future, this accounting technique blows gross and net margins straight off the chart since the company has not had to allocate capital to provide them. Got that?

Didn't know to ask that question before you bought? Caveat emptor, baby. It's not like this question wasn't out there being asked, since Forbes ran an article on March 6 detailing the same transaction described above and questioned whether such revenue recognition was a sustainable practice. Oh, and by the way, in the three days after this article came out MicroStrategy rose more than 50%, shooting any consideration of market efficiency right out of the sky.

The Websters New Collegiate Dictionary defines risk as "the possibility of loss or injury: peril." By investing in any company you are assuming risk. By investing in a company with a huge market capitalization in comparison to its revenues, your risk is all the greater. The only weapon you have against this risk is knowledge. Not warm fuzzies from message board participants. Not analysts reports, not news articles from the Motley Fool. Your own knowledge, acquired before you buy, is your best friend in the quest for superior market returns. Would technical analysis have saved investors from this massive loss, or the ones suffered by the biotech companies? Ill give you a hint. The answer is no. Technical analysis would not have been able to predict the events that caused them to drop.

You see, risk has come to be seen as the path to superior investment returns. And it is, to a point. Because the risk must be weighed against, not seen as an asset. Risk is the thing that can take your money away from you, in the blink of an eye. This type of event should be a lesson to all of us. Several lessons, really.

Unless you are lucky, in a real market run, you cannot "get out before the drop." MicroStrategy opened down 60% from its close the night before. When a potential risk manifested itself, everyone lost, and fast.

One risk, taken on gleefully by management with the approval of the shareholders in the case of MicroStrategy, came to fruition. Come again? Approval of the shareholders? You heard me. Shareholders have been demanding greater revenue growth, focused on it like laser beams. MicroStrategy provided spectacular revenue growth, even though it had to be very aggressive with its accounting to get there. And the company, its management, and its long-term investors became very, very rich in the process. So long as the company's revenue numbers were growing, its investors were happy to accept the rewards.

Now that accepted risk has bitten the company squarely on the derriere, as it realized that it could not continue to recognize so much of its revenues up front. This happens from time to time. Risks, be they foreseeable or not, do turn to reality all the time. Investors who accepted this risk by investing in the company, whether they knew it or not, have no one to blame but themselves for being on the wrong side of it. If you knew the risk, you just got unlucky. If you were unaware of the risk, then your loss had nothing to do with luck at all.

Where to for MicroStrategy? Well, they do have some significant revenues for the next 24 months already contracted for, but otherwise I'd have to be awfully sure that they're dealing straight and conservatively with their books before I'd even consider it. I've been bitten from not being careful before, and I'm not willing to let it happen again.

Fool On!

Bill Mann, TMF Otter on the Boards.

(Exit, pursued by a bear.) - William Shakespeare, The Winter's Tale