MicroStrategy starts war with shorts, but enemy''s within

E-business software provider MicroStrategy has declared war on short sellers, investors who profit by betting a stock will fall, but the company might be its own worst enemy.

In a letter to shareholders Thursday, the company asked its investors to help protect the company from excessive short selling, which executives claimed played a significant role in the stock's unfettered collapse in the past year. While acknowledging the downturn in technology stocks, "management believes that the current stock price is also attributable in part to heavy selling pressure from short selling," said MicroStrategy CEO Michael Saylor in the letter.

The letter apparently worked. Shares soared 76 percent Thursday and tacked on another 12 percent Friday to trade just below $6. Analysts weren't impressed. They said the true irony of MicroStrategy's letter to shareholders was that the company's own miscues left the door open for short sellers.

Investors who "short" stocks are the bane of many companies because they profit from a company's misfortune and plunging market capitalization. Shorting a stock means borrowing shares to sell, then "covering" the loan by buying the company's stock on the open market.

Here's an example. A short seller, banking on a sharp decline in a particular stock, might borrow 100 shares of the stock from a brokerage firm at $20 a share and immediately sell the shares for $2,000. If the stock were to fall to $16 a share, the short seller could then buy 100 shares to return to the broker for $1,600 and pocket the difference less a small commission fee.

If they guess wrong and the stock appreciates, short sellers must buy back the shares at a higher price and, in theory, there's no limit to how much the short seller could lose if the stock continues to gain ground. Shorts have made a small fortune as the Nasdaq has plunged from its all-time high set in March 2000.

In his letter, Saylor urged shareholders to take possession of MicroStrategy shares by pulling them into their accounts. Shares registered in a broker's name or held in a margin account are loaned to short sellers. Shares registered in an individual shareholder's name that haven't been purchased on margin cannot be "loaned" out to short sellers.

"Our stock wouldn't be where it is right now if the short sellers hadn't piled on us," Saylor said during an interview Thursday. "I think (Thursday's) stock price reflects the sentiment that our shareholders want to do what they can to support this company."

Several analysts disagreed with Saylor's conclusion, suggesting that while a handful of loyal shareholders may have followed the company's directive, a more plausible explanation for the 76 percent surge was that short sellers immediately began to cover their positions by buying shares before any buy-and-hold investors took action.

"Frankly, (the shareholder letter) is a little hard to figure out," said Jim Pickrel, an analyst at J.P. Morgan. "It's hard to gauge how much of this is related to the letter and how much of it is short covering. The stock's going to be a bit tougher to short for a little while, but I don't think this will have much of an impact in the long run."

A little history
MicroStrategy's letter to shareholders is just the latest development for a company that has seen its stock top $300 in March 2000 before tumbling to a low of $1.75 earlier this month.

Analysts said MicroStrategy's "business intelligence" software is technically sound, but a series of management blunders that hurt the company's credibility on Wall Street, a slowdown in information technology spending and intense competition has sent the company reeling. Analysts said MicroStrategy's business performance coupled by a restatement of sales and earnings and the Securities and Exchange Commission probe that followed practically invited short sellers, who target distressed companies.

MicroStrategy's software lets companies comb their databases for sales trends, customer behavior and other hidden patterns useful for marketing plans. It competes with Cognos (Nasdaq: COGN) and Business Objects (Nasdaq: BOBJ).

Things turned sour for MicroStrategy on March 20, 2000 when the company announced it would have to restate its sales and earnings for 1997, 1998 and 1999--which had helped to propel the stock to such a high level--to reflect the fact that the company had lost money rather than turned a modest profit in 1999 and earned only half as much as it as it had previously reported in 1998.

These were no minor adjustments.

For example, sales for 1999 came in at $151 million, down from the original report of $205.3 million. Instead of earning 15 cents a share for the year, it actually posted a loss of $33.7 million. The aberrations between what MicroStrategy reported for sales and earnings in 1997 and 1998 were also off by a considerable margin, sparking 25 class action lawsuits and the SEC probe. The SEC investigation culminated with Saylor and two other executives paying out more than $11 million in fines without admitting or denying wrongdoing.

One analyst at a major brokerage firm who picked up coverage of MicroStrategy from a colleague said it didn't take much time to for him to figure out the company had serious issues.

"Let's just say that after meeting with (Saylor) for the first time, we agreed to disagree," the analyst said. "He wanted to talk about technology. I wanted to talk about the business. I mean, this was a guy who actually argued that there were 35 days in some months.

"The company has never turned a profit, continues to burn through cash and derived about 90 percent of its sales last quarter from its installed base," he said. "There's no growth. Throw in the slowdown in technology spending for even the best companies and you get a good idea of just how much trouble these guys are in."

On April 3, MicroStrategy warned analysts that it would miss estimates yet again, predicting sales of between $47 million and $51 million in the quarter and loss of between 31 cents and 37 cents a share.

It also said it would cut one-third of its work force in cost cutting move as part of its effort to "refocus on our core business intelligence business" and predicted it would achieve profitability by the end of this year.

The "toxic" loan
MicroStrategy's biggest mistake could have been raising $125 million in a convertible loan last summer from Promethean Asset Management, a New York-based hedge fund that has provided similar loans to a number of companies including eToys, Entrade (Nasdaq: ETRD) and Ariad Pharmaceuticals (Nasdaq: ARIA).

In investment circles, these convertible loans are known as "death spiral" or "toxic" loans because companies' stocks have a nasty habit of falling below $1 after they are taken out.

And those are the fortunate companies. Many others end up in bankruptcy court. This, according to analysts and executives at companies who have dealt with these hedge funds, is no coincidence.

Terms of the loans typically call for the lenders to be repaid in stock and the farther the stock falls, the more shares the borrower must pay. If the borrowing company can't meet the repayment terms, the hedge fund effectively takes control of or a significant minority interest in the company.

If the company can pay, the hedge fund take the interest--usually in the range of 6 percent to 9 percent--as well as the principal and moves on to the next client.

These hedge funds are Wall Street's answer to the Las Vegas pawn shop, the places companies desperate for financing turn to when the capital markets and traditional lending sources will have nothing to do with them.

As Dale Schmidt, a manager at the Potomac Internet Short Fund, put it: "Companies have to find the money to keep the doors open. But the potential price could be the losing control of your company."

MicroStrategy "was going to do this huge secondary offering but the wheels fell off after the SEC probe," said one analyst who spoke on the condition of anonymity. "They needed money so they went to the financing of last resort. The irony here is MicroStrategy took out a loan that encouraged the people they were borrowing from to short its stock. And while the hedge fund won't admit it, that's what's been going on."

The house always wins
In MicroStrategy's case, this convertible loan was coming due this June and the company didn't have the cash to pay it off. Faced with the prospects of having to either pay the loan or fork over the shares and sustain the enormous dilution to the value of its common stock, Saylor worked out a refinancing deal--announced with the company's April 3 profit warning--to buy his company some more time.

"If converted in the original manner at current levels, MicroStrategy would have had to issue over 50 million shares to convertible preferred shareholders, inflicting serious dilution on common shareholders," First Albany analyst Mark Murphy wrote in a research note. "The deal was restructured so that some of the convertible preferred shares are redeemed for cash in the near-term ($25 million), while other convertible preferred shares are exchanged for Series B, C and D preferred shares with conversion prices of $5, $12.50, and $17.50 per share."

Promethean and other hedge funds have been tagged by a series of lawsuits from borrowing companies in recent years, accusing them of short selling shares in the respective companies to drive down the share price and garner a larger percentage of the company's common stock when the borrower failed to meet the repayment date.

Repeated attempts to contact Promethean founder and CEO James O'Brien were unsuccessful Thursday, but he did tell Bloomberg earlier this year "every one of our investments becomes more valuable as the issuer's stock price increases, and conversely, every one of our investments becomes less valuable if the issuer's stock price declines."

However, Promethean could short sell the stock of a company it holds a note on all the way to basement and then usurp the shares to cover their positions when the company fails to meet the terms of the loan.

In either scenario, the hedge fund wins. If the company continues to flounder, the stock plummets. If the stock falls, it pockets the proceeds from shorting the stock. Eventually, the company runs out of money and the hedge funds swoops in and takes a huge block of common stock to cover its position.

If the company recovers, the hedge fund gets back the original loan plus interest and moves on to the next desperate company.

A chief financial officer at one technology company said his firm managed to repay its convertible loan to Promethean before the stock market collapsed last spring. He said the amount of short selling of his company's stock increased dramatically shortly after the loan was signed.

"Whether the shorting was done by Promethean or by people who closely watch what they do, I don't know," he said. "You could never prove it either way. But I can tell you that we would never do that deal again. Not in a million years."

Shorts a scapegoat?
When pressed, Saylor acknowledges that his stock's poor performance "brought a lot of shorts into the stock" in the past year.

As of March 9, 5.8 million shares, or roughly 20 percent, of MicroStrategy's shares on the open market were being shorted. By comparison, Cisco Systems (Nasdaq: CSCO) and Sun Microsystems (Nasdaq: SUNW) had only 0.9 percent and 0.6 percent, respectively, of its available shares in this same position. Amazon.com (Nasdaq: AMZN) was perched at a remarkable 58 percent.

"I sent out the letter to tell our shareholders that it was not in their best interests to let these shares sit in a margin account and be available to short sellers," Saylor said. "This short selling has put a lot of pressure on our stock. We had to do something."

Saylor said a combination of his letter and MicroStrategy's recent restructuring will put the company back on track and fend off short sellers, but analysts have their doubts.

David Hilal, an analyst with Friedman Billings Ramsay, estimates MicroStrategy has about $105 million in cash, but $40 million earmarked for Strategy.com, MicroStrategy's messaging subsidiary. Factor in a $25 million cash payment to Promethean for the convertible loan refinancing, and MicroStrategy has $60 million in the bank.

If the company breaks even in the fourth quarter as it has promised, MicroStrategy will be OK, but it will " require solid execution without much leeway," Hilal said.