We expect a lot from those who give us financial advice. When an analyst at a brokerage house publishes a buy recommendation for a stock, we would like to believe that a lot of careful work and balanced thinking went into it. Alas, we live in an imperfect world. When analysts don't do their jobs properly, our money is at risk. Bad research is dangerous—it is superficial thinking dressed up as investment advice.

Let's use Alphanet Telecom (TSE: FAX) as a case study.

Readers of this column may know that Alphanet Telecom is in our Technology Portfolio as a short sell. I only initiate short positions if I feel strongly that a stock is highly overvalued and will fall 50-70% over 1-2 years. But in the January 16th edition of the Investors Digest, you will find a glowing article written by analysts from the brokerage firm of HSBC James Capel declaring Alphanet Telecom to be a buy. What's the story?

First some background - Alphanet's claim to fame is the long distance service it started late last year that uses voice-over-the-Internet technology (the technical term is voice-over-Internet Protocol or voIP for short). International long distance calls are governed by a settlement system—part of the toll charge for each call is paid to the country receiving the call. Since the receiving country can't easily monitor voIP calls, Alphanet could avoid paying settlements and thereby undercut the traditional long distance carriers. The result will be windfall profits. At least that's the view of Alphanet's management.

The Investor's Digest article agrees. Alphanet, with its "compelling fundamentals" and its current "attractive valuation" will (by their estimate) generate US$70M in revenues this year and US$177M next year.

So what's wrong with this picture? When reading an investment opinion, I use a five-step reality check. Let's put the Investor's Digest article through it.

How many sides to the story?

If an analyst is parroting the claims of management, what good is that? Even if everything management says is 100% true and above board, you are still left to cope with the important things that management doesn't say.

The article fails the test. The story presented in the article is nothing more than a recital of what can be found in Alphanet Telecom's promotional literature.

Kick the technical tires

Is the company's technology properly assessed? High tech and buzzwords go hand in hand. The analyst has to cut through the gee-whizzery and ask down-to-earth, does-it-work questions.

The article doesn't say much about the technology being used by Alphanet but a casual reader is left with the implication that Alphanet is on the leading edge. The implication isn't accurate.

Alphanet's voice-over-data technology is proprietary. It was developed a couple of years ago when Internet Telephony was in its infancy. Since then, the industry has moved rapidly. An open international standard (technically known as H.323) has been created for voice-over-Internet transmission. Equipment manufacturers such as Lucent, Motorola and 3Com have quickly introduced small Internet Telephony Gateways that do what Alphanet's systems do. Alphanet will either have to make its proprietary technology interoperate with the new standard or deploy custom designed equipment. Either way will result in extra expense. The good news for Alphanet is that the technology works. The bad news is that as Internet Telephony Gateways become widely available, something will happen to their business. Something like...

Competition

Does the analysis cover who the company will be competing against? How tough will the going get? You can tell a good analyst by how well they understand a company's competition. Why? Companies are reluctant to come forward and say who (or what) the biggest threat to their business is. It's up to the analyst to ferret this out. I would never take any analyst's opinion seriously if they don't do a good job of assessing the competition.

The two things that the article says about Alphanet's competition are both wrong. First, it claims that it would take a competitor "two years to launch a similar service". As we said above, the equipment is becoming widely available. Anyone wanting to become a long distance provider will be able to buy off-the-shelf equipment that will do the job. In fact, there are already over 30 companies with the same idea as Alphanet, some with much deeper pockets and (surprise!) some that are actually much farther ahead than Alphanet is.¹ It's Economics 101, low barriers to entry means high competition (and low profits). The long distance business will eventually become a low-margin business like the Internet access business. The advantage will go to large companies who can wring profits out of slim margins.

The analysts' second mistake is they believe traditional carriers like Bell and AT&T aren't a threat because they won't switch over from their existing networks to voIP. This is a serious underestimation. The mainstream carriers are masters at protecting their turf. Any company that tries to take big money away from them must first run a legal gauntlet to get it. Take ShadowTel for example. This is a long distance company based in Ontario using (you guessed it) Internet Telephony technology. They wanted an exemption from the contribution payments that long distance companies pay. The case came before the CRTC and wouldn't you know it, the CRTC (with the help of a legal opinion from Bell Canada) turned them down.²

If Alphanet gets through any legal wrangles, that's when the gloves come off. It's not going to be pleasant. The carriers are billion-dollar companies with an established customer base who just happen to own the data highways. Last time I checked, Alphanet had $25 million in cash reserves—and falling.

Internet Telephony will change the telephone industry. But to think that a small company will march in and make windfall profits is hopelessly naive. Small companies will have to fight it out with the phone companies and the Internet service providers. Any guesses who the casualties will be?

Which way is the wind blowing?

What are the trends in the company's line of business, and how will they affect the company's outlook?

If you're looking at Alphanet Telecom as a long-term investment, the plummeting cost of long distance calls is critical. Bell recently announced a flat 10 cent per minute rate to anywhere in Canada. Teleglobe (who will be relinquishing its monopoly on overseas long distance this year) has committed to reducing its prices by 15 per cent this year and then again in 1999. Not even the international settlement system is immune. The Federal Communications Commission (FCC) in the U.S. want to cut the settlement payments from an average of $0.88 per call to $0.15-$0.23 per call within the next five years.³ Where the U.S. goes, Canada is likely to follow. But wait. Isn't Alphanet's entire profit model dependent on high international settlements? The Investor's Digest article doesn't have anything to say about any of this.

Another trend: Bell, AT&T and Sprint are all aggressively entering the Internet service provider market. With their existing networks, they are well suited to providing a one-stop shopping experience for business communications needs (this means Internet, private networking, long distance and even voIP, if need be). Where does this leave companies that just provide one service?

The numbers game

Does the article provide a sound basis for its financial projections?

Alphanet has annual sales of US$8M, most of it from its current business of providing hotel fax services. Since starting its long distance business they have had $100,000 of long distance revenue. The analysts at HSBC James Capel think that Alphanet's revenues will rise to US$70 million in 1998. This is an immediate red flag. Not counting their existing business, this means an increase of 67,000%! Our intrepid analysts happily predict revenues of US$500 million in 4 years. A look at the facts reveals that Alphanet will have its work cut out getting even a fraction of this year's $70M target. In Alphanet's most recent financial report⁴, we find that their $100,000 in long distance revenue represents 600,000 call minutes (or 16.7cents/minute). To get $70M they will have to generate a boggling 420 million minutes of call traffic this year. This poses a technical challenge. Internet Telephony Gateways are still relatively small and don't scale up well. Mundane but critical aspects like the network administration and billing systems must be put in place. Never mind the marketing costs needed to drum up the call traffic in the first place. Take these roadblocks into account and the likelihood is that Alphanet will fall far short of its targets.

At its current (April 17) price of $16.10, Alphanet Telecom has a total market value of $160 million, over 15 times its current sales and almost twice the exceedingly optimistic 1998 sales projections of the HSBC James Capel analysts. Investors in the company are assuming that Alphanet has won the war even before the first shot has been fired. They may be disappointed in what happens over the next couple of years. The mainstream carriers will fight tooth-and-nail to keep their customers, international settlement payments will plummet, new competitors will come into the market, long distance prices will continue to fall relentlessly. HSBC James Capel may forecast $177M revenue for Alphanet in 1999, but I doubt if they will even hit $15M.

Conclusion

You cannot take any analyst's opinion on blind faith (mine included!). The facts are what matters. A good analysis is an opinion based upon an in-depth view of all the facts. What does this mean for the technology inestor? Any investment in a company must be backed by your own in-depth assessment of the facts—the more you know about a company and its industry, the better.

Some important notes:

• First, I don't want readers to think that HSBC James Capel is any better or worse than any other brokerage. I have successfully short sold half-a-dozen companies in the past and sad to say, each one was given buy recommendations by brokerages of one sort or another. To give them a break, they are sometimes hard pressed to cut through the technical claims of high-tech companies. And in this heated bull market, we all have a natural psychological tendency to see potential gold mines where none exist. On the other hand, brokerage firms have been (in my opinion) slow to address the serious problems with the advice that they are giving to their clients. This can only hurt their business in the long run.

• Second, although I have short sold Alphanet Telecom in our portfolio, this is not a call for you to do the same. Its price is hype-driven. Short selling is a high-risk activity and should not be taken lightly by the average investor.

A Technology Portfolio - The story so far...

Rule #1 - Never buy or sell anything just because it's written here. That would break one of the Laws of Investing—don't act on hot tips. The portfolio is a personal work-in-progress where we can apply principles of investing in a real-life situation. It is not to be construed as financial advice, since there is no way that the high-risk situations we are dealing with will be suitable for all investors. In particular, if the short positions go bad, it can hurt. I hold positions in some of the issues—it's more interesting and more effective than paper trading.

Comments

The market has been unstoppable. The Dow easily broke another century mark at 9100. I continue to believe that stock market prices levels are historically expensive and that they will eventually revert to the mean. Hence, the Portfolio has a high short holding. It will be interesting to see how we do against the market averages when the market suffers a serious decline. But even despite the strong market, our short positions continue to do very well - so much so that the Portfolio is still beating the NASDAQ Composite. Zitel had a brief resurgence from $9 all the way up to $16 (illustrating well the dangers inherent in short selling) but then rapidly lost ground. C-Phone looks increasingly green around the gills —a few more bad earnings reports and it may be curtains. Alphanet should have its next quarter's earnings released in May sometime.

Actions

In February's column, we put a protective sell stop for Digital Equipment at US$55 which was to be moved progressively higher if the stock price continued upward. As a result of favourable publicity on Compaq's takeover, DEC continued its ascent and hit a peak of a little over US$62 before it started to fall. Our position in Digital Equipment was liquidated on Feb 26th at US$57.625. As it turned out this saved us from a sudden drop in DEC's price to below US$50 when Compaq announced lower-than-expected results for the current quarter. As mentioned last time, the proceeds were to be invested equally in Inacom(ICO-NYSE) and additional short sells in Alphanet Telecom (FAX-TSE). This was done at the prices that were effective on Feb 26th. The results are reflected in the positions shown in the "Technology Portfolio" table.

Technology Portfolio

Footnotes

¹ You can see a partial list of competitors at www.pulver.com/nextgen. Jeff Pulver, a guru on voIP runs this informative site. One interesting competitor is USA Global Link, a long distance company that has pledged to spend $500 million on a long distance Internet Telephony service.

² See the Jan 26th edition of Ian Angus' Telecom Update at www. angustel.ca/update/up117.html and the CRTC ruling itself at www.crtc.gc.ca/eng/telecom/order/1998/o9828_0.txt.

³Check out http://www.fcc.gov/Bureaus/International/News_Releases/1997/nrin7028.html for details on FCC plans on cutting settlements to foreign countries. The FCC views high settlements as an unfair subsidy to foreign telephone companies. It has asked for a multilateral re-examination of the existing arrangement, failing that it will take unilateral moves to cut payments.

⁴ A copy can be found at http://www.techstocks.com/~wsapi/investor/reply-3469060.

Wynn Quon, MBA, Director, R & D Mitel Corporation

© Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published May 1998