Friday, November 25, 2005

TASR stuns the street -- Redux

It’s been almost two years since stun gun maker, Taser International (TASR), was one of 2003’s mightiest stocks. Sporting a board that included the then-highly-respected Bernard Kerik, whose reputation was dinged during a failed effort to appoint him head of the Department of Homeland Security, TASR’s trading symbol was changed today to TASRE – after it received a delisting notice from NASDAQ due to a delayed 10Q filing.

Despite its many business problems, TASR’s stock took off after I pointed out many of these problems in the enclosed January 2004 e-mail – rising from a split-adjusted $8 to as high as $33.45 this January. Since then, the stock has tumbled 78%. As such, TASR is an object lesson in the enormous risks associated with selling short -- where it is often possible to be right about a company at the wrong time -- and thus disastrously wrong about its stock.

-----Original Message-----From: Peter Cohan [] Sent: Friday, January 16, 2004 3:26 PMSubject: TASR stuns the street

You may be stunned to learn that Taser International is one of the best performing stocks of the last year. Its high market valuation, raft of lawsuits, and high levels of insider selling have attracted short sellers. It remains to be seen how much longer the short sellers will suffer.

TASR’s stock has skyrocketed 2,656% in the last year from $3.65 to $122 (an 11% jump today in the wake of its announcement of a 3-for-1 stock split.) This 73-employee Scottsdale, AZ-based manufacturer of stun guns has generated $16.5 million in sales and a profit of $1.7 million over the last year – for a stunning price earnings ratio of 265.

Granted, TASR’s sales doubled from $5.9 million in the first nine months of 2002 to $12.1 million for the same period of 2003. On September 30, 2003 Congress approved the Defense Appropriations Funding Bill for 2004. Included in this allocation of funds was $1 million for the purchase of its products for the United States Army. And since June 2002, TASR has burnished its board with former New York City police commissioner Bernie Kerik.

But TASR has managed to get itself in quite a hornet’s nest of litigation for such a small company. It faces potential damages totaling more than 35 times its net worth.

TASR allegedly failed to pay commissions to a distributor. In March 2000, Thomas N. Hennigan, a distributor of TASR’s products from 1997 to 2000, sued for $400 million worth of unpaid commissions. In April 2001, Hennigan died but his case is still being prosecuted by his estate. A trial date is pending.

TASR allegedly violated a firing technology patent. In April 2001, James F. McNulty Jr. sued TASR alleging that certain technology used in the firing mechanism for its weapons infringes on McNulty’s patent. Specific damages have not been sought but the litigation remains unresolved.

And TASR has been sued by the families of individuals who have died after police hit them with TASER gun “fire.” TASR claims that the deaths resulted from high levels of drugs in the victims’ systems.

TASR has also gone on the offensive against stock message board posters. In May 2003, TASR sued a Yahoo message board poster -- dubbed ubswarbird -- alleging a series of false and defaming statements about TASR and its officers.

TASR’s founding family – the Smiths – has been selling shares.

Since September, Phil Smith has cut his Taser stake by 39%. He sold 136,142 shares at prices ranging from $27 to $80 for a total of $5.5 million, while acquiring an additional 11,392 Taser shares by exercising warrants at prices ranging from $11.88 to 66 cents.

Meanwhile, since late October, Thomas and Patrick Smith have reduced their stakes by 21% and 11% respectively. Thomas sold 46,000 shares for $3.1 million and acquired 10,000 shares by exercising warrants at $7.21, and Patrick sold 32,000 shares for $2.1 million.

Short sellers, who control 62% of TASR’s float, must be in a world of hurt. Earnings are forecast to grow 73% from $0.45 in 2003 to $0.78 in 2004, 28% of its P/E of 265.

If a short seller is right at the wrong time is he really right?

Sunday, November 20, 2005

Massachusetts Brain Trust

The Massachusetts’s brain trust (MBT) is the source of thousands of high tech companies and millions of jobs. What is the MBT? What has been its performance? What challenges must it address to maintain its track record? What are the implications for government leaders?

The MBT is a collection of capabilities that has helped propel the state to the forefront of technical innovation – creating shareholder wealth and employment in the process. The capabilities include:

  • Universities and research laboratories. Harvard, MIT, Massachusetts General Hospital, the Dana Farber Cancer Institute and many others exemplify the notion of Massachusetts as a global talent magnet;
  • Venture financing. On a per capita basis, Massachusetts invests the most venture capital in the US. American Research & Development, founded in 1946 by George Doriot, a professor of industrial administration at Harvard Business School, was one of the first venture capital firms – made famous by its investment – which grew from $70,000 in 1957 to $355 million in 1971 -- in MIT-graduate, Ken Olson’s, Digital Equipment Corporation;
  • Entrepreneurs. Many of the students who come to Massachusetts for school decide to start businesses including Analog Devices, Analogic Technologies, EMC, Lycos, Staples and Teradyne. Furthermore, university faculty members have founded major local firms such as Akamai Technologies, Bose, and Biogen;
  • “Yankee Ingenuity.” Massachusetts has a culture of frugal experimentation which leads venture capitalists to make smaller, more-focused investments leading to higher investment success rates; and
  • Government support. For example, Massachusetts defense contractors get funding from the Navy and Air Force as well as the Small Business Innovation Research (SBIR), a US Department of Defense program that provides $500 million in early-stage R&D funding for small technology companies.

While it’s not clear exactly how this collection of capabilities emerged; it appears that intellectual capital came first and the supporting capabilities followed. According to Alain Hanover, managing director of Navigator Technology Ventures, the core of the MBT is Massachusetts’s schools, such as MIT and Harvard, and its research laboratories. Students come to the schools from around the world, they like the area, they get jobs after graduation, and when they see that the potential rewards of entrepreneurship exceed the risks, they start companies.

The MBT has demonstrated a remarkable resiliency in the face of economic cycles. According to Mike Goodman, Director of Economic & Public Policy Research at the University of Massachusetts Donahue Institute, the Massachusetts economy has always been cyclical – driven by waves of innovation. This has been true from the industrial revolution to the minicomputer to the dot-com era.

The state economy must reinvent itself – it must come up with new ideas and create new companies and new industries around them. Massachusetts is good at product development and prototyping but not so good at mass production. So when a technology market begins to commoditize, Massachusetts moves on.

Massachusetts is not a low cost producer. It can’t rely on masses of land. The weather is bad. But it does have an innovative and entrepreneurial spirit. One thing that has changed is that the pace of reinvention has picked up. In the past, Massachusetts could ride a technological innovation for a generation. Now, innovation comes in much shorter -- five or 10 year -- cycles.

Through these economic ups and downs, the MBT’s creative contribution has been impressive. Evidence of this economic creativity comes from MIT which has produced 4,000 MIT-related companies employing 1.1 million people which have annual sales of $232 billion. In determining where to locate, a survey of 1,300 MIT corporate founders ranked the following factors as critical:

  • Quality of life in their community;
  • Proximity to key markets;
  • Access to skilled professionals;
  • Low business cost; and
  • Access to MIT and other universities.

MIT gives back to Massachusetts. While California workers (162,000) benefited the most from the creation of the MIT-related companies, Massachusetts (125,000) came in a strong second. The 1,065 MIT-related firms headquartered in Massachusetts employ 353,000 people worldwide and 125,000 people in the state. They generate worldwide sales of $53 billion.

These companies represent 5% of total state employment and 10 of the state’s economic base. MIT-related firms account for about 25% of sales of all manufacturing firms in the state and 33% of all software sales. While only 9% of MIT undergraduates are from Massachusetts, more than 42% of the software, biotech and electronics companies founded by MIT graduates are located in Massachusetts.

MIT’s companies are also at the forefront of knowledge-based industries. They are highly dependent on a workforce of skilled professionals. They rank product quality and reliability, customer service and innovation as the most important ingredients to their success and build a corporate culture which stresses innovation, cooperation and individual attention.

Unfortunately, all this economic productivity cannot obscure the challenges that Massachusetts has faced in the last five years. It had 3.5% to 4% unemployment before the dot-com crash in 2000 which resulted in unemployment peaking between 6% and 7% in 2002. While state data show Massachusetts has posted job gains in 11 of the past 12 months, it has regained only 25% of the 207,000 jobs lost since employment peaked in 2001.

Nevertheless, Massachusetts’s 2005 unemployment rate has fallen back to 4%. But this decline has more to do with a drop in the number of workers than to an increase in the number of jobs. According to Hanover, What happened in the last few years is that people who were in Massachusetts left the area and fewer students who came to Massachusetts for school ended up staying here. So the workforce size declined between 2002 and 2005. Now it is becoming more difficult for companies to find people skilled in software, biotechnology, and telecommunications.

What is the next big thing? Goodman believes that the answer lies in biotechnology, life sciences, health care technology and nanotechnology – particularly as it might be applied in electronics or computers. According to the Massachusetts Biotechnology Council, 8% to 10% of all drugs in development are being researched by Massachusetts firms.

The strongest recent job growth has come in health services, reflecting Massachusetts’ reputation as a hub for medical research and hospitals. Health services accounted for 11.7% of Massachusetts’ jobs in the first half of 2005, compared with 9.2% nationally. Health care is a “normal good” meaning that as a region’s wealth increases, its spending on health care will increase as well. This feature, coupled with the growth of demand for health care as 77 million baby boomers age, is likely to propel demand in the future.

The challenge for Massachusetts is that a lot of the wealth created by biotechnology and nanotechnology will not be labor intensive. Therefore, the jobs lost due to the dot-com crash in IT and telecommunications are not in the same industries where Goodman sees future jobs. Workers cannot go from jobs in telecommunications manufacturing to those in health care. The IT skills are not transferable for displaced workers.

Over the last several years, Massachusetts corporations have rebuilt their profits; however, they are not creating enough jobs to pick up all the slack in the work force. Nevertheless, IT firms with large Boston outposts, such as Cisco Systems, Hewlett Packard, Sun Microsystems, and Oracle, have picked up some of the slack.

So until the next big technology wave swells; the MBT is down but not out.

The MBT story suggests some thoughts and raises some questions for government leaders, including the following:

  • Academic excellence. The starting point for a successful knowledge economy is universities which attract the world’s best students. Since university reputations seem to follow those of its faculty, recruiting world class faculty and creating an environment which supports their work is critical. If government leaders seek to create a knowledge economy, such recruiting initiatives could be an excellent first step;
  • Risk culture. Entrepreneurship is inherently risky. The typical track record of a venture capital firm is to have one big “win” for every 10 investments. The reason that US venture capitalists are willing to take these risks is a culture – helped by its capital markets; legal and tax systems -- that help manage the risks. Furthermore, US capital markets create opportunities to realize the gains from creating successful new businesses. Without such a risk culture, students will not see entrepreneurship as an attractive career option; nor will investors seek returns in new venture creation. Could government leaders do more to create a risk culture?
  • Entrepreneurs. Massachusetts has a long history of successful entrepreneurship. Other regions and countries had histories of entrepreneurship which may have lapsed. For example, Portugal showed its entrepreneurial mettle way before Massachusetts did. 500 years ago, Portugal had a small home market but tremendous skills at building ships and sailing them to rich overseas markets. Can Portugal apply new skills to rekindle this spirit of entrepreneurship in the 21st century?
  • Capital. A high tech economy depends heavily on the availability of capital willing to make the risky bets on such entrepreneurs. Venture capitalists depend on large pools of pension fund and endowment money to put a portion of their capital into the hands of the venture’s general partners. The pension funds and endowments in the US have the freedom to place a portion of their funds at substantial risk because the track record of venture capital has been better than virtually any other asset class. And a key source of these superior returns is a vital market for initial public offerings and acquisitions of the companies these venture capitalists help create. Are the conditions for a booming venture capital industry present in other regions?
  • Government support. Government certainly plays a substantial role in the Massachusetts high-tech economy. It provides significant funding -- through defense contracts and medical research grants – that have formed the basis for many of the great technical innovations driving the many companies cited above. Yet in other ways – such as making specific investment decisions or selecting entrepreneurs – the government leaves the driving to the venture capitalists. Could government leaders play a similar role to support a high tech economy?

Friday, November 11, 2005

Ending M&A Groundhog Day

M&A is having a great year but is it good for shareholders and employees?

For too many of the companies involved, M&A deals end up leading shareholders to relive the worst day of their lives over and over again. But there is a way out of this M&A Groundhog Day (Groundhog Day is the 1993 movie in which a cynical weatherman, played by Bill Murray, is forced to continuously re-live the worst day of his life until he learns to become a better person). 2005 could well be the busiest year for M&A since 2000, with $745 billion in transactions as of September 27, according to analyst Richard Peterson of Thomson Financial. Deals in 2004 totaled $829 billion, which was up sharply over the preceding three years, although it’s only half the record $1.7 trillion done in 2000.

M&A goes through phases. In the 1960s, the highest flying companies on the stock market were conglomerates – such as Gulf & Western and ITT – which used their stock to buy companies that increased their earnings per share. As these conglomerates engulfed and devoured their prey, their earnings grew, their stock valuations rose, and they used their more valuable stock as currency to do new deals. This kept working until the 1970s when stagflation – a combination of inflation and slow growth -- devalued the stock of conglomerates and made it useless as currency to keep the schemes afloat. In response to the ensuing conglomerate discount – the stock market’s lower valuation of conglomerates -- a wave of divestment and corporate focus lasted the decade until the merger wave started all over again with the leveraged buyout (LBO) Masters of the 1980s.

A big reason for the recent spurt in M&A is the desire to remedy this decade’s version of the conglomerate discount problem which resulted from a 1990s merger wave – hence Viacom splitting into two: MTV and CBS and Cendant spinning off its four core businesses into separate publicly traded companies: a real estate company that includes Century 21 and Coldwell Banker; a hospitality company that holds brands Ramada and Days Inn; a travel group encompassing Orbitz and CheapTickets; and a rental-car company owning both Avis and Budget. Once the focus trend plays itself out, don’t be too surprised if a wave of mergers driven by a new ‘convergence’ trend soon follows.

Why do these waves keep repeating themselves? One reason is that people respond to incentives. If you pay enough money to encourage deal doing, that’s exactly what you’ll get. And there is no doubt that deals generate enormous pay days for those who are driving them – including M&A bankers and the CEOs who head up the companies being acquired. This year, for example, M&A bonuses are set to rise an average of 20% on strong performances for the industry’s top deal makers. Wall Street professionals typically make a base salary of $100,000 to $250,000, with the remainder coming in the form of the bonus. A senior investment banker on Wall Street could receive an average of $2.2 million to $3.3 million this year.

And CEOs can make even more as a reward for selling their companies. For example, in January 2005 Boston, MA-based Gillette agreed to be acquired by Cincinnati, OH-based Procter & Gamble for $57 billion. Gillette CEO James Kilts walked away from the deal $185 million richer while Boston lost yet another corporate headquarters and 1,100 jobs on top of the 12,000 Kilts cut during his four year tenure with Gillette. Clearly those job-losers were not cut in on the M&A loot.

Neither are shareholders. Numerous studies suggest that most mergers destroy shareholder wealth. For example, a Chicago Tribune/A.T. Kearney study of 50 mergers between January 1999 and September 1999 found that 69% of the surviving companies lagged their industry average in shareholder returns in the two years after the deal closed. About 70% of surviving companies underperformed their peers five years after the deals closed according to Kidd Stewart (2001).

But not all mergers are bad for shareholders. While the average big merger does not do much for shareholders, there are big performance differences across industries. This is the conclusion of a Peter S. Cohan & Associates analysis of 30 big mergers concluded between 1998 and 2001. These 30 mergers averaged $39 billion and the stock prices of the average acquirer lost 6% between the date of the merger announcement and March 29, 2002 as compared to an 11% loss on the S&P 500.While the average acquirer’s stock among these 30 performed 5% better than the S&P 500 from the date of the announced merger there are wide differences across industries. For example, financial services, energy, and consumer products mergers performed very well while telecom, media, and tech (TMT) mergers were shareholder value destroyers.

Consider these shareholder value-creating examples:

  • Citigroup, which announced its acquisition of Travelers for $36.9B in October 1998, outperformed the S&P 500 by 224% from the date of this announcement;
  • Philip Morris, which announced its acquisition of Nabisco for $19.3B in June 2000, outperformed the S&P 500 by 143% from the date of this announcement; and
  • El Paso Energy, which announced its acquisition of Coastal for $15.7B in January 2000, outperformed the S&P 500 by 122% from the date of this announcement.

By contrast, consider these three telecom and tech value destroyers:·

  • WorldCom, which announced its acquisition of MCI for $37B in October 1998, underperformed the S&P 500 by -90% from the date of this announcement – before ultimately filing for bankruptcy;
  • JDS Uniphase, which announced its acquisition of SDL for $41.1B in January 2000, underperformed the S&P 500 by -76% from the date of this announcement; and
  • VeriSign, which announced its acquisition of Network Solutions for $217B in March 2000, underperformed the S&P 500 by -71% from the date of this announcement.

While none of these studies can provide definitive answers, they do suggest that there might be a way out of this M&A version of Groundhog Day in which shareholders are forced to relive waves of acquisition and divestitures as conglomeration and focus go in and out of favor on Wall Street.

Peter S. Cohan & Associates just completed a study of successful diversification in the payment services industry – companies that process credit card and other financial transactions -- which offers general lessons for corporate acquirers. Our study of 10 diversification businesses created by eight payment services providers (PSPs) found that the PSPs added an average of $559 million to their 2004 sales and $103 million to their 2004 operating income through 20 acquisitions costing an average of $429 million.

How did these PSPs succeed? Their approach to M&A takes seriously the basic blocking and tackling of diversification strategy. Specifically, the PSPs in our study apply the following management discipline:

  • Pinpoint large, rapidly-growing, profitable markets;
  • Focus only on such markets where the acquirer’s core capabilities – such as operational excellence, marketing, technology-based innovation – will give the acquirer a competitive advantage in the new market;
  • Negotiate a reasonably priced deal with a company that offers a beachhead into this new market; and
  • Grow market share by integrating the acquired company with care while ‘pouring in’ the acquirer’s core capabilities.

If CEOs wish to end the M&A version of Groundhog Day, this diversification discipline can help them mend their ways.

Tuesday, November 08, 2005

When to sell

To many observers, the end to the rapid rise in housing prices – frequently referred to as a bubble – has been just around the corner. While I have been early on the timing, this earliness raises one of the most fundamental investment questions: ‘When to sell?’ Here are two such sell indicators:
  • Sell when the company puts its name on a sports stadium
  • Sell when the company is featured on the cover of a major magazine or newspaper

The Enron stadium in Houston is no more, Boston’s Fleet Center passed from existence after its merger with Bank of America, and Foxborough, MA’s Gillette Stadium will soon be changing its name in the wake of its merger with P&G.

But today’s focus is the second of these sell signals. In the case of housing, a major sell signal was flashed with the October 16 publication of a long article, Chasing Ground, in the
New York Times Magazine about Toll Brothers. This article was an ode to the voracious appetite of Robert Toll, this luxury housing developers’ founder, for buying land and developing it into houses.

Today, a mere three weeks after the publication of this article,
Toll Brothers announced that it saw the end of the housing boom. If an investor had sold short Toll Brothers stock and covered after today’s announcement, the investor would have secured a 12% return.

Not bad for a 3-week bet; nor one I would close off just yet

Friday, November 04, 2005

Investment Lemmas

Do stock prices instantaneously reflect all available information about a company and its industry? While the debate continues, I’ve observed certain investment lemmas (in mathematics, a lemma is a truth used as a stepping stone to a larger result rather than an important statement in and of itself.) These lemmas work for while – until they don’t.

For example, I’ve found two lemmas: it possible to make money in the market by investing in a basket of stocks that ride temporary episodic trends and by finding individual stocks that float upward on guidance momentum. Here’s what I mean:

  • Temporary Episodic Trends. Coinciding with new presidents, I’ve noticed widespread changes in the economic environment. If an investor can identify such "episodic trends" early, there is money to be made. For example, in May 2001, I developed the W-Industrial Complex (WIC) index of stocks in energy, defense, and selected retail and media properties which I believed would benefit from Bush’s policies. Last time I checked, the index was up 150% vs. the S&P 500 which was down 10%. This investment strategy works well as long as an investor is willing to get out before the end of the trend. As oil and natural gas prices tumbled last month, I began to wonder whether the WIC’s viability as an episodic trend was over. When such trends find themselves as headlines in the major newspapers and magazines – as oil industry profits did this week or did in December 1999 (with Jeff Bezos gracing Time’s cover) – it is often a sign to head for the exit; and
  • Guidance Momentum. In my newsletter I have been able to pick a few stocks each year which seem to outperform the averages significantly. In these cases -- such as Boston Scientific in 2003 or Whole Foods in 2005 -- the stocks exceeded growth projections and raised guidance consistently and investors piled into them. Each quarter that these companies were able to beat and raise, new investors bid up the stock. The higher price raised the stock’s P/E ratio – making the inevitable slip up precipitously painful –- particularly for the most recent investors. In the case of Boston Scientific, problems with product recalls interrupted the stock’s upward momentum. Whole Foods has yet to hit its inevitable rough spot – it could be as simple a problem as failing to beat and raise in its next quarterly earnings report. But once a stock falls from guidance momentum grace – it becomes "dead money" unless it can re-establish its ability to beat and raise quarter after quarter.

If investors are lucky enough to identify stocks that pass these tests, they can make short-term profits – as long as they also have lemmas that tell them when to get out.

Perhaps in investing there are no larger results – just the accumulation of small ones.

Wednesday, November 02, 2005

Reasons not to invest

I generally do not invest in the stock ideas mentioned in The Cohan Letter for three reasons:
  • I am very reluctant to invest in individual stocks because I do not understand what moves their prices up and down;
  • Even though I have developed some rules of thumb that appear to link financial performance and prospects to stock price, unexpected events can eliminate the usefulness of these rules; and
  • I find that once I have invested in a stock, I lose some of my objectivity. I tend to place less weight on information that suggests I might have made the wrong decision and to place more weight on information that confirms my decision.
These reasons come to mind in thinking about why I did not invest in the three energy stocks – Suncor, Tesoro Petroleum, and Devon Energy -- which I had mentioned in the previous issue of The Cohan Letter. All these stocks had enjoyed tremendous increases in value over the previous year and had benefited from the rise in oil and natural gas prices.

During October, all of these stocks plunged as much as 10% or more from their prices at the end of September. By applying this newsletter’s 2% stop-loss rule, anyone who had invested in these stocks would have limited their losses.

The companies were financially strong, were leaders in their industries, and several of them had tremendous earnings growth prospects, according to analysts.

However, their stock prices depended on a continued rise in the prices of oil and natural gas. A month ago, this seemed like a safe bet for three reasons:
  • Since hurricane season, which had knocked out so much gulf coast oil and natural gas production, was still in full swing. Another big hurricane or two could have delayed the return to production of much gulf coast capacity – or added to the damage;
  • A terrorist attack on oil refining or production facilities in the Middle East was always a possibility; and
  • A blast of cold weather in the Northeast and Midwestern US could have increased demand and caused a spike in heating oil and natural gas prices.
What actually happened was that supply of oil and gasoline increased in October causing prices to drop. The new hurricanes that happened in October did not damage the energy production facilities and no terrorist attacks occurred. I noticed prices dropping from about $3.30 per gallon to about $2.50 for mid-grade unleaded gasoline. And a forecast for warmer than normal weather in the Northeast during the first two weeks of November caused natural gas prices to fall from their peak.

In some respects, investing in energy is easier than in other industries because at least prices are publicly available. Such is not the case in, say, the pharmaceutical or technology services industries. But the basic point is that stock prices can move based on the perception of how an industry’s profits might change in the future. In the energy industry, there are several factors that could move those profits and many different scenarios for how those factors could evolve. Given the difficulty of knowing which of these scenarios is most likely, committing capital to their stocks is quite a gamble.