Trade of the Week: E-Loyalty (ELOY)

I purchased some shares of E-Loyalty (ELOY) yesterday. E-Loyalty is a fairly unremarkable Customer Relationship Management (CRM) consulting company. It was spun-out of a company called Technology Solutions in early 2000 in a crass and fairly typical attempt to capitalize on all things remotely Internet related (thus the E-Loyalty name). Its venture backers were TCV and Sutter-Hill, two later stage players who likely saw an opportunity to take a call center consulting company, gussy it up a bit and make some quick money.

Incredibly, E-Loyalty hit a high of almost $350/share in mid-February of 2000, just a couple weeks after the spin-out became effective, likely giving the VCs hundreds of millions in paper profits. But the worm quickly turned and the stock headed into a free fall. It was down 50% just a couple of months later and by the end of 2003 was trading at just $3.65/share, down almost 99% from its high.

It’s not that there haven’t been good reasons for the stock’s price decline. The company’s revenues declined from $212M in 2000, to $147M in 2001, to $87M in 2002, and what looks to be about $80M in 2003. GAAP losses in 2003 will probably be between $17M-$20M, up from last year’s $15M. The company only has about $29M in net cash on hand it looks like it will continue to bleed cash for at least a few more quarters.

So why in the world did I buy such a “winner”? First, and most importantly, it was recommended to me by a friend of mine who is an analyst and who use to cover the CRM software space. He knows that I like “fallen angles” with compelling valuations that are arguably in the midst of a turn around so he told me about ELOY. I tend to buy at least token positions in all the stocks he recommends because even if they go down I will at least be able to give him a hard time about it. It doesn’t hurt either that the last stock I bought on his advice, Chordiant (CHRD), made me some decent money. His advice along with a quick peak at the fundamentals on Yahoo! Finance was enough for me to buy 1,000 shares yesterday.

What I found when I looked on Yahoo! Finance was that from a financial standpoint, E-Loyalty had many of the characteristics that I look for when I screen software stocks for new ideas (although ELOY is clearly not a software stock). According to Yahoo, ELOY had a market cap of $39.9M and, as I quickly calculated, a net tangible book of $47.2M, meaning that the company was selling at 15% discount to tangible book which provides, as Benjamin Graham would say, a nice margin of safety. Net cash was $29M and operating cash flows, while negative, we only in the $2M-$3M/quarter range indicating that the company could operate for a minimum 2+ years without having to raise more capital. Revenues were likely to be about $80M in 2003, which means that the company an enterprise value to sales ratio of only 0.14.

While overall financial performance has indeed been terrible in the past few years, there were indications that revenues were either stabilizing or even growing. In fact, the company pre-announced a positive quarter earlier this month that resulted in a single day jump of over 36% from $3.56 to $4.85. Since then the stock had been climbing steadily upward as new buyers trickled in, many likely drawn by some of the same things I was now seeing.

Outside of the revenue growth, a few other things attracted me to the stock. One was that I had already seen stronger than expected Q4 software license sales at a number of CRM vendors, such as Seibel and E.piphany, indicating that the CRM software market was indeed coming to back to life a bit (and with it, presumably CRM consulting) and another was the fact that consulting firms tend to have highly leveraged exposure to incremental revenues. What I mean by this is that because consulting firms must eat the cost of unbillable consultants, any increases in the utilization of consultants drops almost entirely to the bottom line. With gross margins of only 16% in Q3 03, ELOY clearly had very poor utilization (healthy consulting firms have around a 50% gross margin). Given this, even modest revenue growth would likly have a significant impact on the bottom line, possibly generating the company’s first ever GAAP profitable quarter sometime in 2004 and my experience with these kind of stocks suggests that once they hit GAAP profitability they tend to experience another leg of significant price appreciation as the market bids them up into a comparable multiple range vs. their competitors. One final factor that attracted me was that the stock was very thinly traded (only 17,000 shares/day). This lack of liquidity suggests that if the stock has in fact turned the corner, it could run up very rapidly and that even slightly positive news could generate significant gains.

As I said, this quick analysis, plus the opportunity to give my friend merciless grief if the stock went down, was enough to buy the token 1,000 shares of the stock yesterday. I did resolve however to spend some time this morning doing a more thrurough analysis of the stock to see if I should try to take a meaningful position in it.

With that in mind, this morning I went through a number of Eloyalty’s recent SEC filings. As often happens, this closer level of analysis revealed some negative surprises. The first and most important surprise was that the company had actually issued about $21M in 7% Preferred stock in December 2001, mostly to its VCs TCV and Sutter Hill. I should have caught this when I looked at the balance sheet on Yahoo! Finance but I didn’t (preferred stock is listed in the shareholder’s equity section, not as debt). The net effect of this was to dramatically reduce the “margin of safety” in ELOY by putting $21M in preferred stock ahead of the common. Thus rather than trading at a discount to tangible book of 15%, ELOY is actually trading at over 1.5X tangible book. Since the preferred is convertible into common it means that there were about 65% more shares outstanding (on an “as converted” basis) than I thought meaning that despite what Yahoo! Finance said, the effective market cap of the company was $63.6M instead of $39.9M. (In my experience incorrect market caps are a consistent issue with Yahoo! Finance, I highly recommend taking their market cap numbers with a grain of salt. It makes you wonder how many people are making decisions using the wrong numbers…)

Another negative surprise was that the preferred was sold to TCV/Sutterhill at about $5/share and has been freely registerable since mid-2002. With the stock now suddenly trading above their cost, there’s a risk that the VCs could start selling their shares or worse yet, distribute them all at once to their LPs, which would kill a highly illiquid stock like ELOY.

While these were significant negative surprises, it’s not clear that they outweigh the positives. Indeed, most of the factors that were initially appealing about ELOY proved true on closer inspective. Staff utilization was indeed depressed at around 60% thus indicating the potential for significant margin expansion should revenues grow. Revenue declines and negative cash flows were also decelerating sharply and the company could clearly become profitable with a little bit of wind at its back.

So what to do? On the one hand, the preferred stock really makes ELOY an unattractive holding. It eliminates what appeared to be a big margin of safety and it creates a huge (relative to its liquidity) overhang on the stock that could fall at any time. On the other hand, if ELOY’s revenue growth is for real, the stock could quickly turn GAAP profitable and start generating cash, something that would likely lead to significant stock price appreciation given what has happened to other stocks in similar situations recently.

My decision is made complicated by a few more facts: 1) I know that my friend will be talking up the stock to other people on the street potentially giving the stock a lot of trading momentum. (He even convinced his boss to buy it which is a very risky move.) 2) I bought the stock at $5.70 yesterday (E*Trade screwed me on my fill relative to the market but that’s another post…) and it closed at $6.27 today, up just under 10% in 48 hours. Given the stock had only average volume today that indicates to me that there are almost no sellers out there right now which is a good technical situation for the stock. 3) The company reports next Tuesday. Stocks typically are either strong or weak going into an earnings report and this stock is clearly strong. Thus there’s little reason for the positive trend to reverse itself prior to the report next week.

All that said, I am not going to add to the position. The liquidity will play against me if I try to buy a lot of shares and if bad news comes out I will get creamed. I am also scared to death of that overhang, especially in light of the fact that the VC’s are now sitting on a 25% gain. I suspect there will be pressure on them to start some limited sales shortly because the same thing happened to us at Mobius with a couple of our illiquid small-cap holdings. Net, net I am probably just going to put in a stop-loss at $5.75 (I have learned my lesson on stop-losses) and let it ride until just before the earnings call (2/10). I’ll reevaluate then and see if I want to risk the report or not.