September 26, 1996
Type: Buzzard-Bait Short
HQ: Marina Del Rey, CA
Closing prices: $7 3/4 bid, $7 7/8 ask
Trailing 12-month sales: $126.0 million
Trailing 12-month earnings per share: -$0.64
Last quarter reported: 3Q Fiscal '96 (June)
Next quarter reported: 4Q '96 (September), around November 8th
Consensus EPS for quarter: $0.00 (that's right, flat)
Fool Ratio: N/A
Trade: SELL 890 shares
The Fool Portfolio returns to shorting after a year and a half absence, having located a financially troubled software enterprise that appears to have more room to fall.
The Fool Portfolio has not featured a shorted stock in it since we covered our Paychex short (at an impressive 32% loss) on March 31, 1995. In other words, we've just undergone a shortless year and a half. It's been a great year and a half, with the market skyrocketing and the Fool Portfolio skyrocketing further, but you know there's always been a little something missing. We're talking about a little money on the other side of the table.
We like shorting stocks, and we believe in doing so. The idea is to learn to make money both ways on the stock market, up and down, preferably at the same time. As we've written in The Motley Fool Investment Guide, if you purchase stocks because you believe you can find undervalued ones, you should just as easily be able to locate overvalued situations to sell short. Because most market watchers look one direction, up (that's where they hope their stocks can go), much of the investment world is focused on hoping it can squeeze a given stock for a few points more on the upside. When you Foolishly short a stock, you're turning that point of view on its head, looking downward at the potential for a fall. While we would never encourage taking this point of view for the market overall (because it really does go up and up and up over time), we do consider it useful and profitable to do so in the case of individual stocks.
Along comes Quarterdeck (Nasdaq:QDEK). The company, a developer of software products, concentrates on three separate fields: utilities ("more from your PC without spending more on hardware"), Internet ("complete solutions for all Internet users"), and remote computing ("information management -- anytime, anywhere"). (Parenthetical comments lifted from the company's annual report.) The problem with Quarterdeck is that many of its products are either just another entry in a competitive field, or near obsolescence due to the changing dynamics of the software field. Consequently you have a company bleeding red ink that must continue to spend money to market itself and keep its products on the shelves, while at the same time offering products that the public seems increasingly less inclined to purchase. This investment conforms to our Buzzard Bait approach, originally outlined in our SmartMoney magazine column several months ago. (More about buzzard bait below.)
You also have a stock that has fallen in the past year from a high of $39 1/2 to a low of $5 5/8. Whether the overall market rises or falls from here, we believe that QDEK at its current price of $7 3/4 has room to retest those lows, giving us a good shot at hitting our target return of 20% on this transaction.
The approach is only suitable for aggressive, experienced investors who can stomach above-average risk and follow the stock market more closely than most.
Before moving on to discuss and analyze Quarterdeck, it behooves us to digress briefly -- but importantly -- on the subject of shorting. As we know that a fair number of people watch the Fool Portfolio, and in some cases mimic it, we want each of you to be clear exactly what shorting is all about, and the risks that it entails.
First off, if you're new to shorting, go directly to our article on shorting in the Fool's School, one of our 13 Steps to Investing Foolishly. It is, in fact, the Eleventh Step, which means those who consider shorting should only do so as experienced investors who've been investing in and learning from the Dow Dividend Approach, small- and medium-cap growth stocks, etc., for long enough to feel confident and self-reliant.
Second, shorting is by nature a short-term activity. This does not mean you need to quote your stock portfolio five times a day; it does mean you need to stay on top of this investment on at least a weekly, if not a daily, basis. Thus, shorting is most appropriate for those of us who truly enjoy investing, are fairly aggressive at heart, have the time to dedicate to the process, and can stomach investment losses should failure rear its ugly head.
We've written at length about shorting, both online in our Fool's School, and offline in our Motley Fool Investment Guide. Further, among Fooldom's interactive features are a Quarterdeck message folder, and a Shorting Stocks folder. We encourage you to make use of these resources to learn more about short selling. And to help inform you even before using those resources, please read our Foolishly Answered Questions (FAQ) section on the subject of Shorting Stocks.
Quarterdeck's products appear in most cases to be a generation behind. Further, it is trying to make a business off charging for these products, when many of its competitors are marketing similar offerings at no charge.
Quarterdeck is a software hybrid of SYMANTEC and NETSCAPE, offering a portfolio of utilities and online communications products to consumers and business. The company met with a tremendous amount of success in 1995 when memory prices were dear and any software that was even vaguely Internet-related was white-hot; QDEK's sales catapulted from below $50 million to north of $70 million. But some of the varnish has since worn off Symantec and Netscape. The company with characteristics of both, but lower market share, now appears to be behind the eight ball.
Utilities. The company's first major product was a memory management program called QEMM (Quarterdeck Extended Memory Manager), a product that still forms the basis of QDEK's utilities lineup. Branching out from QEMM, Quarterdeck has also developed or acquired a number of products that improve or optimize your system's ability to function. Some of the more significant utility offerings in this regard are: Cleansweep, which uninstalls 16- and 32-bit programs with full archiving; Game Runner, which improves the speed of computer games; MagnaRAM 2.0, which provides 32-bit compression to increase the memory of Windows-based PCs; WINProbe, a diagnostic, trouble-shooting program; and HiJaak, a program that optimizes a computer's ability to handle graphics.
Two secular business trends have crunched Quarterdeck's utility business: improving operating systems and cheap memory. With regard to the former, Microsoft has continued to push out the boundaries of its operating system, offering more and more functionality with Win95 (and now the new Windows NT, with its superior networking functionality). This is why Symantec (maker of the Norton suite of software products -- NT Tools, Norton Utilities, etc.) has seen its business deteriorate over the last year, causing the stock price to crash to a near 52-week low. And Symantec has an agreement with Microsoft to integrate some of its functionality into Windows, unlike Quarterdeck. With each upgrade of Windows, utility companies have to slap together an even more compelling package to get those extra dollars from users even as they see the bottom-end of their market erode.
With regard to memory management, this business opportunity is only important when memory is more cost-prohibitive than software. With the recent collapse in memory prices and the trend toward 32-megabyte configured PCs, products enabling you to squeeze every drop out of your old silicon (specifically, DRAMs, or Dynamic Random Access Memory chips) have become less important over the past year. Quarterdeck is basically competing against Moore's Law, the theory that the price of computing power will continue to be cut in half every eighteen months. This means that the functionality of Quarterdeck's core QEMM offering has to double every eighteen months or QDEK loses ground, a feat we believe near impossible. The day when memory is cheaper than the software to enhance it has dawned, not playing out to the benefit of companies like Quarterdeck.
Internet and remote computing. Quarterdeck broke into the the online communications market last year through its acquisition of Infonautics. The company got a Mosiac browser, server software, World Wide Web authoring tools, and an intelligent agent called Web Compass that helps one navigate the Web. Quarterdeck then went on to supplement its new business with the acquisition of Datastorm and its product ProComm Plus, a Windows-based communications application that was once prominent in the old world where modem connections were the rule and TCP/IP (Internet) connections were the exception. Today, computers talk to the Internet more than they do to each other (they talk to each other through the Internet, in fact). Quarterdeck got a lot of oomph out of this lineup in fiscal 1995 when online services were just becoming popular and Netscape, SPYGLASS, and Microsoft were all only beginning to compete. Even QDEK's WebTalk and Internet Relay Chat products are being one-upped by many, including America Online, which is about to integrate AOL Phone into its software and is giving away Virtual Places for free. Heck, Intel gives away a free Internet chat product!
While Netscape and Spyglass are not easy competitors, Quarterdeck's biggest enemy in this market may well be Microsoft. Although initially reluctant to embrace the concept of online, the Redmond, Washington-based giant has been in the market with a vengeance over the past few months and has taken significant chomps out of Quarterdeck's online business. Today, Microsoft gives away a browser with its operating system and is also offering key parts of its server software for free as well. Unlike Netscape, which managed to build critical mindshare in the business community, Quarterdeck has essentially been left high and dry. Even the intelligent agent functionality of WebCompass has been, and probably will continue to be, co-opted by newer and better versions of the Netscape and Microsoft browsers.
In trying to build its business through frequent -- almost relentless -- acquisition, Quarterdeck may be paying too high a price for its prizes. The ProComm decision is one such example. Quarterdeck purchased Datastorm the very quarter that the company released a significant upgrade to its communications software. Volume then dropped off precipitously, leaving the company having paid a steep $65 million (issuing 5.2 million shares) for the acquisition. With the currently wide availability of graphically-based communications and e-mail products, the company's investment in a fading market seems an odd way to grow.
Regardless, the attractiveness of Quarterdeck's product line appears on the wane. More importantly, the company is being forced to make money off of products that compete with similar stuff being offered by other companies for free.
Quarterdeck lost a tremendous amount of money in its fiscal '96 third quarter, and we expect the losses -- while not of the same magnitude -- to continue for at least the next few quarters. Further, the company appears to have lost Street sponsorship.
There's no way to sugar-coat this: Quarterdeck is losing money hand-over-fist. Take a look at the company's June quarter financial statements and you can't miss it:
Net revenues $16,022,000
Cost of revenues $11,252,000
Gross margin $4,770,000
So right off you have $4.8 million left after cost of sales comes out of sales. Now comes what really hurts:
R&D expense $5,365,000
Sales and marketing $17,089,000
General and administrative $9,216,000
Each of these on its own exceeds the company's gross margin. Taken together (with a $1.7 million restructuring charge added in), you have total operating expenses of $33.3 million, making for a second-quarter operating loss of $28.6 million. Net income (after throwing in other income and a tax benefit) came to $22.9 million, or $0.73 per share.
More worrisome, perhaps, was that the figure of $16.0 million in sales for June compared to $28.0 million in sales for the comparable quarter during the year before. In other words, the company's business has recently been shrinking. And operational cash flow for the nine months ended June 30th was -$29.6 million. The company has issued both more equity and more debt to keep itself afloat, but it's clearly a troubled financial enterprise.
Taking this out of the context of a single quarter, Quarterdeck did actually turn a profit in the first half of fiscal '96. Thus, the problems described above are mostly recent and should not necessarily be construed as long-lasting. No doubt the cost-cutters and damage-control guys over there in Marina Del Rey are doing their darnedest to minimize expenses to close the year. So do we expect QDEK to lose 73 cents more in the fourth quarter? No way. But the trend (decreasing sales) will be hard to overcome, and we're expecting to see red ink through at least the end of the year.
That's interesting when you look at consensus earnings estimates (according to First Call) over the next couple of quarters. The four firms who follow Quarterdeck currently report September quarter estimates of $0.00 per share (with the high being a one-cent profit and the low being a one-cent loss). And the forecast for December is a four-cent profit.
We believe the likelihood of the company meeting or exceeding Street estimates is extremely low; the likelihood of Quarterdeck underperforming, conversely, appears quite high. As the company is currently in the hole with a '96 loss so far of 62 cents, and the analysts show expectations for a 35-cent loss for the year (just one quarter to go), we're even more confident.
All of which suggests that this company is losing, or has lost, Street sponsorship. When analysts stop following a company, they don't necessarily announce it with a press release. They just stop updating their reports, stop updating their estimates. In Quarterdeck's case, that appears to be the game afoot. All of which leads us to talk about buzzard bait.
One of our shorting approaches has us aiming to find companies already beaten down, that we believe will be beaten down further.
A number of different approaches to short selling exist. In The Motley Fool Investment Guide, we wrote about our traditional one: focus on outstanding companies whose shares have simply been grossly overpriced by a fanatical market. Later, we identified a second approach in a recent SmartMoney column we wrote on shorting: the buzzard bait strategy. With this approach, you're looking for stocks that have been crushed by diminished expectations, that are financially weak, whose businesses look increasingly moribund. Another aspect of such companies is that they lose their Wall Street sponsorship (read: insititutional buying), sometimes for a long time. Quarterdeck is a pick very much in this tradition.
The American capitalist in us would like to see the company rebound. We don't necessarily enjoy seeing any enterprise fail. That said, part of the efficiency of our economy and markets is the inevitable penalty they place on companies that are not meeting customer's needs at the right price at the right time with the right product. Growth and decline are as natural a part of our American economy they've been a part of the world's political history or our planet's organic processes. The goal of investing is to make money, and the goal of shorting is to profit off unnaturally inflated values. While we don't expect Quarterdeck to go bankrupt anytime soon, we do foresee the possibility of the shares declining to new lows. And as Fools who always like to have a bit of our money "on the other side of the table," we are going short Quarterdeck, underneath the buzzards' lazy circles.
We have no interest in watching Quarterdeck fail, or drift off the map. We simply believe the stock has further room to fall over the near term. Over the long term, we wish QDEK business success.
This stock is volatile. Just last week, it rose from $6 to $8 1/8 in one day following the release of two new products. Thus, one must be prepared for above-average volatility in a stock whose price sits in the single-digits.
Keep in mind also that investors can no longer short stocks that drop under $5 per share. While this doesn't affect anyone who shorted already above $5, this is always a factor to understand and bear in mind.
Finally, one of the more despicable things we've witnessed in following the stock market for more than a decade is the actions and behavior of other short sellers. Some of these people systematically spread dubious -- or outright false -- information, in an effort to scare investors away from certain stocks and make their quick bucks off the declines. Don't expect that from Fooldom. We'll continue to work as hard as we can to reflect accurately the current prospects of QDEK or whatever other company we write about.
That is to say, we don't feel we need to "cheat" -- as has been so common among short sellers, a reason why they're a favorite probe of the SEC -- in order to win on our investments, long or short. If we're right, we'll be right. If we're wrong, we'll be wrong; we'll drink that medicine however it tastes, and as usual, you can expect us to describe and interpret that taste on a daily basis right here in Fooldom.
So to close, we wish best of luck to the people at Quarterdeck Corporation. While we do hope their stock drops 20%-25% over the near term (as we think it can), we hope that over the long term the fellas in Marina del Rey beat the pants off of their competitors and lead all of us to a more efficient use of our computer resources. Fool on!