In my May 1998 column I discussed an example of bad stock analysis. We dissected a research report from analysts at HSBC that recommended Alphanet Telecom. Alphanet Telecom is a small company providing competitive long-distance service using voice-over-packet technology. The story was that they would offer low-cost international long-distance services by avoiding the existing international settlement accounting system. The analysts, in a report to their retail clients (covered in an article in the January 16,1998 issue of Investor’s Digest), thought that Alphanet would pull in $100 million in revenue in 1998 and $177 million in 1999. Based on the hype, investors had driven the stock up to a high of $20. The HSBC report had severe problems, which we pointed out in our May column. It was way off base in its assessment of the competition; it overstated Alphanet’s technological capabilities and to top it off, the analysts assumed ludicrously unrealistic growth rates. The report was a "castle-in-the-air" job.

Since that time, Alphanet’s performance has been dismal. In my May column I predicted that Alphanet would be lucky to get $15 million in sales in 1999. My forecast turned out to be supremely optimistic. The year isn’t over yet but the company will definitely not make $15 million. Why? Because it declared bankruptcy on February 8.

Here’s What Happened

• June 1998: Alphanet releases its first quarter results. To hit the HSBC target, it needs US$25M in long-distance revenue. How much did it actually make? $0.1 million. More unsettling is that the company uses up US$6.9 million in cash (25% of their reserves) on this underachievement. Curiously enough, investors are nonchalant. The stock price remains in the $15 range even though the company is venturing out on thin ice.

• August/September 1998: Alphanet issues $21 million in new securities to the investing public. The underwriter for the deal is none other than HSBC, the company behind the rosy report. I am sure this is pure coincidence.

• October 1998: After two months of denial, investors start questioning the company’s future. Something is drastically wrong with either the technology or the service it is offering because the sales are not materializing. Through September and October, the stock falls—gradually at first and then with alarming speed. In late October, Alphanet’s CEO Andre LeBel releases a statement saying, "Alphanet’s fundamentals, including its technology advantages and network capabilities, continue to be a winning combination". By this time, the stock is down to $7.

• November 4, 1998: The spam hits the fan. Alphanet announces terrible second quarter results. Long-distance revenues are a mere US$0.8M and the company is burning cash at a suicidal rate. In the first nine months of the year Alphanet has spent US$30M. With only US$11.5M left, the company has no option but to seek refinancing. This isn’t the "winning combination" investors were expecting. The castle-in-the-air hits the ground with a thud. The stock falls 50% in a single day on massive volume, closing at $3.61. CEO LeBel releases a statement saying, "The fundamentals are in place and we believe the outlook is positive".

• Dec 29,1998: The company shows signs of imploding. The entire U.S. sales force resigns en masse to join a competitor. A senior employee sues the company for $1.0M in back pay. Alphanet is now a penny-stock, hitting a low of $0.66.

• February 8,1999: In a short news release, Alphanet announces that it has been unable to find additional financing. Without additional investment, the company has no choice but to go into bankruptcy.

Lessons Learned

1. Relying solely on brokerage advice is not a sound strategy. I don’t mean to single out HSBC—other brokerages have done research reports that are equally bad.
2. Know what you’re investing in. Picking out the weaknesses in the HSBC report without a good understanding of the technology and the telecommunications industry is difficult.
3. When the CEO says the outlook is positive, it doesn’t mean anything.
4. Read the financial reports. The signs of Alphanet’s cash woes were in black-and-white and were hard to miss. Investing without the basics of accounting and finance is like buying cows by candlelight.
5. Don’t buy acorns at oak prices. At its peak, investors valued Alphanet at $200 million even though its sales were negligible. This meant that there was no room for error. Even if it had managed to survive, the company’s stock price would still have had little long-term upward potential.
6. Beware of pure coincidences.

Market Outlook

The last few months has seen record highs in the NASDAQ technology index. Internet mania came to the forefront in January as stocks like Amazon and Yahoo breached all standards of valuation and common sense. Early investors in these stocks have made a twenty-fold or more return on their money. But like all speculative bubbles, the great tragedy will be that the majority will lose. I see the Internet frenzy as a sign of the impending death of this bull market. Here are some market predictions:

• The market breaks in March with a drop of 15-20% in the market. It will be swift and sudden but once again investors buy the dip and the market recovers.
• There is a final upswing as the narrowly based mania in Internet stocks spreads to the wider market. This carries the Dow to within shooting distance of 12,000 by summertime.
• The fundamentals in the world economy pull the rug from under the market. The debt situation in Russia and Latin America, the comatose Asian economies, the consumer debt binge in North America take its inevitable toll. The next break in the market happens in the fall and unlike previous dips will be a serious crash that signals the beginning of a bear market that will take the Dow down to 6,000 by next year.

In my October column, I talked about using scenarios to fear-proof and sanity check your long-term stock market investment plans. The scenarios given above are the ones I’m currently using. I hope you find them useful too.

Wynn Quon, MBA, Director of Research and Development, Mitel Corp

© Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published March 1999