Rule Breaker Portfolio

Fool To Sell ATCT
October 08, 1997


SELLING

ATC Communications
NASDAQ: ATCT

Type: Small-Cap that became a Micro-Cap
Closing prices: $3 7/8 bid, $3 29/32 ask

Trailing 12-month sales: $97 million
Trailing 12-month earnings per share: $0.06
Last quarter reported: Q4 Fiscal '97 (June) (-$0.08)
Next quarter reported: Q1 '98 (September)
Consensus EPS estimate for quarter: -$0.01e
Fool Ratio: 0.98

Trade: Selling 600 shares

OVERVIEW

After four disappointing quarters, even the long-term investors in us are willing to let this thing go.

When we purchased ATC Communications almost one year ago, the company had twenty-five cents in earnings per share and $94 million in trailing revenue. Now, twelve months later, ATC has six cents in trailing earnings per share and $97 million in revenue for the year just ended. Margins, which were close to 10% last year, have slipped to negative numbers, and revenue, which was growing sharply last year, declined 30% in the latest quarter. Suffice it to say that things are not going as we had hoped, by any measure.

The Fool has lost 83% on this purchase in one year and the $11,400 hit has weighed heavily on the portfolio. By now it couldn't get much worse unless the stock went to zero, eh? Some readers will say that we're bailing out a little late, and that the stock is probably due to finally rebound. Maybe it is. But looking at the industry, the latest quarter, and the estimates going forward (which are a flare shot in the dark, presented by two lone analysts) we have to go with our feelings on this one and sell in hopes of finding something better.

Our feelings? We invest in small caps with the aim of achieving market-beating growth, and this thing ain't growing. Being long-term investors, if there was substantial hope looking forward we'd be more than willing to hold the stock, of course. The industry doesn't present a significantly promising outlook, though -- at least not enough promise to keep us waiting, cage door open, for this pigeon called ATC to come home again. Competition in telemarketing is fierce and prices are falling, along with margins and earnings. What was hot one year ago has made an abrupt about face.

What kept us from selling earlier? The company was always making money until now, and the stock was going down more sharply than was merited, we felt. ATC's stock has flirted with $4 for the past months while the company had positive earnings -- even while turning over a new business leaf under new management. We had some confidence that our guys at ATC could get back on the "growth track" after that leaf was turned. After the surprise loss in the most recent quarter on a large decline in revenue, though, coupled with new negative earnings estimates for at least the next quarter and menial earnings projected for the entire fiscal year, it's finally difficult for us to believe that we can't find a better investment, even with ATC at this price.

We did gain something of value from this purchase, though: lessons. Several Foolish lessons constitute the bulk of this report.

VALUATION

Considering the new earnings estimates, the stock appears fully-valued even at $4, while the industry looks shaky.

Even now at $4 per share the stock has a PEG of 0.98. The only two analysts following ATC now estimate ten cents in earnings per share for the fiscal year that just began, putting the stock at 40 times estimates four quarters out. ATC still has a projected five-year annual growth rate of 30%, but that growth rate was predicted last year, too, and in actuality revenue was flat and earnings decreased by a monstrous amount. If the company does grow earnings four cents per share this year to ten cents, that would be 66% earnings growth after the 76% decline in EPS last year. We would have:

      1996 EPS $0.25
      1997 EPS $0.06
      1998 EPS $0.10e

This isn't the most impressive three year record.

What really matters, though, is what takes place beyond these years, but judging from recent price cutting and the vast number of competitors in the industry now fighting for long-term business (over fifty), we aren't so confident that earnings are going to increase rather than first continue to decrease or remain flat. Beyond the near term, it's likely that competition will force telemarketing companies to consolidate or die in the years ahead. Mergers might lead to a few big companies in the industry, and then economies of scale at the big guys might force the little guys to gasp for air, if not drown outright and disappear. ATC itself has said that it is interested in acquisitions, but with a depressed stock price and a weak cash position, it's difficult to imagine the company making significant purchases in the near future. Mergers might be in ATC's future, perhaps, but we don't invest on the hope of mergers or a buy-out alone.

With $97 million in trailing revenue and a market cap of $88 million, ATC's stock trades at less than one times sales. But the company's run rate is only $84 million ($21 million in revenue last quarter multiplied by four quarters). Meanwhile, AT&T still recently accounted for 30% of revenue, and the giant long distance company is able to turn on and off its business with ATCT like a "faucet," so the certainty of revenue growth going forward is... well, much less certain. Finally, eight new contracts were announced last week, but only two were cited as long-term contracts, and the size of the contracts -- any of them -- was not disclosed. And why not? ATC hasn't been nearly as "public" as shareholders should demand it be. In fact, the surprises and secrecy at ATC have most likely driven away some institutional investors, judging from the past conference calls. This issue is addressed in the next section of this report, too.

Finally, if a company is losing money -- as ATC just did, losing $0.08 per share in the last quarter -- and if its business is low margin and commodity-like even when it is profitable, the price to sales ratio granted is often only around one times sales, and sometimes less. It's hard to imagine this stock rising sharply again unless, logically, both revenue and earnings take off again, and the growth is sustainable. That may happen eventually, but we think that we can find more probable growth elsewhere. In the meantime, ATC's cash position is a little worrisome to us. In the past year the company's cash and equivalents declined from $1.7 million to $624,000, while long-term debt doubled to $4.7 million, and current liabilities stand at $7.8 million. In the last quarter the company had negative cash flow of about $1.5 million, implying that if ATC doesn't become profitable within a few quarters the company may need financing to continue operations and finance its debts.

CONCLUSION
The mistakes made, the lessons learned, and the conclusions drawn...

We did our Foolish due diligence before we bought this stock. We thought that we had a possible high-growth market beater on our hands. So it wasn't a lack of homework that led to a poor decision, it was instead mistakes made in the analysis. Contrary to the obscure rumor that The Motley Fool is actually a compilation of Microsoft, Intel, and NASA technology, constantly churning out hundreds of Foolish articles per month, we are indeed, sometimes unfortunately, human. Being human, we made several mistakes in this purchase that are well worth reviewing, as the lessons learned are the most valuable thing this investment has given us.

The mistakes that we made

1. When we bought ATC every industry stock was soaring. In retrospect, it appears that every one of those stocks was overvalued. At the time, valuing ATC against peers that were even more overvalued turned out to teach a valuable lesson. ATC had a PEG of just over 1.0 when we bought it, while peers had PEGs of 1.5 or higher. (Too bad we didn't short one of them!) Anyway, a stock that is less overvalued than an overvalued peer doesn't make for good value. We already knew this, but the lesson was reiterated.

Evaluating a stock against peers is always useful, and often it can lead to the discovery of an undervalued stock, but a Fool must know what type of measuring stick he is measuring with. A company's peer group alone is not a good measuring stick unless you're objective in valuing that group itself. We should have valued ATCT on its own merits (which yes, we did, but we were hoping for big time growth, which will lead to point two) and we should have discounted the high valuations given to ATC's peers.

2. We projected estimate beating earnings growth after only two strong, blow-out quarters, despite the fact that the company stated that it was often unsteady in earnings growth, because a large order one quarter could skew the results positively. This leads to several other mistakes made, including buying a company that relied on so much of its revenue from one or two clients, buying in an industry that was commodity-like (even inbound call taking, we're learning, isn't as much a proprietary technology as we'd like it to be), and this leads to another point.

3. Buying an industry that we didn't know very well, or enjoy all that much. Who loves getting telemarketed to? Not us. We also didn't learn with enough detail the many changes taking place at both ATC and within the industry. Granted, the industry changes were near impossible to predict, but through more extensive talks with ATC we probably could have learned that it planned to transition into a different mode of business which would alter costs and possibly slow revenue or earnings growth. We bought the stock just after the company had a management change and just before management began to change the business. A lesson to remember, another one that we knew: be careful buying stocks of companies that have just made significant and several changes in management, until you know why the changes were made and what the new management plans to do. This point leads to another mistake.

4. Buying a company that isn't shareholder friendly. As a public company, ATC does a pretty good job at keeping its business private, to the chagrin of shareholders like us. After the second quarter of this fiscal year management stated that it would be more open, and it was for a time, but then it became very quiet again. We're disappointed that management didn't notify shareholders of the severe earnings shortfall that was just announced, and that those earnings were so late in being announced without significant explanation from the company.

What we did right

It may seem hard to believe -- having lost 83% on this investment -- but we actually feel that we did many things correctly, too, while making this purchase. We knew the risks we were taking and the Fool Portfolio was, as always, well diversified before ATC was bought. Even after this stock lost most all of its value, the Fool Portfolio is still going strong. The Fool Port has its foundations in the Foolish Four, and is diversified enough that one position can never destroy it. Also, we of course don't use margin to buy stocks, and we don't buy more of a holding if that stock begins to cascade downward. We never "double down" because -- as was true in this case -- there is usually some reason that a stock is falling, and if you can't see that reason and want to buy more as the stock is falling you open yourself to even greater losses. We don't throw good money after bad.

Of course we also, as said, researched the stock extensively and made our own decision and took full responsibility for it. Again, that's what Foolishness is all about. Even this unsuccessful investment (read: WORST Fool Port investment ever!) in ATC Communications was a Foolish one for us. It was our decision, based on our own research, and so we made our own mistakes and we learned from them. Going forward, we'll now be that much better equipped to spot a good, or a possibly bad, investment thanks to the lessons learned from ATC.

That said, of course the unforeseen always has a new lesson to teach. Even past experience can't compensate for the uncertainty of the future. Otherwise we'd all have nothing but winners. Uncertainty is what makes investing such a Foolishly interesting subject, and one that we enjoy immensely -- winning some and losing some, but winning more than losing in the long run (and hopefully beating the market along the way).

Foolish investors make their own decisions about their investments. Fools that we are, we could easily be selling this thing at the very bottom.

Fool on!