The Sad Truth for Answers Corporation Bulls

After reading “The Long Case for Answers Corporation” (ANSW) I found myself befuddled about how quickly pockets of speculation can form in the markets. It’s amazing to me that investors can so carelessly ignore obvious financial and business risks and apply multiples on future expectations with no regard to appropriate discount rates or the likelihood that the those expectations ever become reality. Where to begin?

First, I agree with the assertions made in the two recent bullish posts on Answers.com (“Answers.com: Still a lot of questions” and “The Long case for Answers.com”), that suggest Answers.com has a nice product. However, by no means does that opinion equate to a company being a good investment. In fact, there are substantial business risks to this small, fledgling enterprise – with a not-so-small market capitalization - when one adjusts the fully diluted share count.

Answers.com disclosed on its most recent conference call that they still get roughly 25% of its traffic from the Google (GOOG) definitions link. This relationship is informal and could disappear any day, especially if Google realizes Answers.com claims at investment conferences that they have a better mouse trap than Google for finding information. Further, they disclose in their 10K that 60% to 70% of its traffic comes from search engines. Simple math would lead an investor to opine that 85%+ of its traffic could be in jeopardy with a simple site redesign by Google.

While I do not claim to be an expert on the algorithms of the search engines, many investors have dismissed the risks associated with Yahoo (YHOO) or Google changing the way they crawl Answers.com properties. This risk should not be ignored considering many Answers.com critics (including the bulls indirectly) have all but confessed Answers.com is heavily reliant of its licensing of Wikipedia content (which helps it in natural language search rankings). If Google or Yahoo decides Answers.com is nothing more than a backdoor to Wikipedia, this would result in a change to the way they crawl Answers.com, leaving Answers.com traffic in major peril.

As many may recall, this issue affected Answers.com in late 2005 as its Yahoo traffic nearly went away for several months (discussed in its conference calls and disclosed in its 10K – “Answers.com has on past occasions suffered from drops in traffic and, consequently, in revenue due to these two separate types of search engine decisions"). Answers.com has disclosed this potential risk in its 10K:

Ultimately, a change in search engine algorithms used to identify Web pages towards which traffic will ultimately be directed or a decision to otherwise restrict the flow of users visiting our Websites, for any reason whatsoever, could cause a significant decrease in traffic and revenues, which would in turn adversely affect our financial condition.

Let me turn to a few of the bullish arguments from the two favorable Answers.com posts recently written on Seeking Alpha. First, both submissions make a valuation argument for Answers.com based on “analyst’s consensus estimates.” Now, I have a very difficult time in the real world (read: not a straight up bull market like we’ve had for 4 years) blindly taking analyst estimates and slapping a random multiple on them to arrive at a price target.

This risky method for determining valuation is magnified when out-year estimates have been missed badly by the company in the past, or are reliant on metrics that assume smooth, linear progress. While critiquing David Gentry’s concerns on Answers.com from Red Herring, Morgan Martindell writes, “Answers trades at approximately 42 times 2007 earnings estimates, and less than 17 times 2008 estimates. While the first multiple may seem lofty, estimates for next year do much to explain the current valuation.” What Morgan should recall is that when Colin Gillis at CanaccordAdams initiated coverage on Answers.com on 2/6/06, his CY’07 estimate was $0.44 on $17.18M of revenues. Mr. Gillis’ price target a year ago was $20 based on the calendar ’07 estimates (or the out-year at the time). Now, one year later, and only three months into calendar 2007, his estimate for 2007 has already been cut by 1/3 to $0.30 on $16.1M in revenues.

This dramatic cut has occurred despite the fact the company has made two "accretive" acquisitions over the past year. Now, Mr. Gillis, and many of the Answers.com bulls, have kept its $20 price target, but are simply using the “new” out-year estimates, of 2008. There are no guarantees, but if there were, I would guarantee Answers.com will never make consensus numbers for that “out year,” and the trend of downward revisions would be very supportive of my assumptions. Just take a look at the company’s most recent guidance for Q1’07 in its end of year earnings press release. Answers.com guided revenues to $2.975M at the midpoint of its range when consensus was $3.05M at the time. I may be splitting hairs, but companies in early growth stages (they have been there for years it feels like) typically have consistent upside to estimates, not the other way around.

There are a few other points in Mr. Martindell's post with which I must take issue. First, he alludes to the strong balance sheet that has $9M in cash with no debt. What he fails to point out however, is that a year ago, the company had nearly $19M of cash and no debt. Between, two small acquisitions, and operational cash burn, the company has plowed through over half of its cash in one year. Given the balance sheets of many competitors, Answers.com is extremely under-capitalized to compete in this space, which I’d argue is a reason the financials – on an absolute dollar basis – are so meager.

In fact, Mr. Martindell supports my argument that Answers.com is a trivial entity when he writes “what has kept Answers in the red are research and development costs and selling and administrative costs. Both of these are less of a negative than they appear at first glance. While a big factor early in the year, R & D costs diminished from 2.6 million in Q1 to 656,000 in Q4. As Answers focuses more on marketing in the future, R & D costs will likely remain low.”

The fact that Answers.com only spent $656,000 in R&D in Q4’06 should say it all and terrify investors. How can a company in the exciting realm of Internet content/search expect to be a viable, competitive entity when it only spends 2/3rd of a million bucks a quarter on research and development? This expenditure is consistent with a company that has a $30M market capitalization, NOT a $143 million market cap! This brings me to the issue of shares outstanding.

I think many investors may be a bit confused when they look at the “cap” of Answers.com. Yahoo, Bloomberg, and other services, are showing 7.8M shares outstanding. This is the share count that the company reports today with financial losses. However, as noted in its 10K, and on their Q4’06 call, on a fully diluted basis, there are closer to 11M shares outstanding. At $13.00, this produces a market cap of $143 million, which seems absurd given $7M of trailing sales, or even $16.1M of estimated forward twelve month sales.

In the vein of accuracy, allow me to point out a few other interesting observations in Mr. Martindell’s post as well as with the company in general. Let’s examine some of the Q4’06 details, about which Mr. Martindell wrote:

The result of these impressive gains is best illustrated by the 2006 quarterly income statement. The most important parts of this statement are a 29.6 % average revenue growth rate quarter over quarter and a 45.1 % average gross profit growth rate quarter over quarter.

First, as many on this site know, Internet usage and advertising are highly seasonal, so looking at sequential growth rates may not be the best metric (Answers.com even states in its 10K “For example, the fourth quarter is traditionally a higher revenue quarter due to heightened advertising spend”). But let’s play along and gauge the 29% QoQ rate against some comps. If we look at a company with a similar revenue base, such as ROO Group (RGRP – no position), well they grew revenues from $2.2M to $3.8M QoQ, or by 73%. Heck, let’s look at two of the best run, most respected, online media companies: Aquantive and Google (no position in either). Both have significantly greater revenue bases off which they must grow, so surely Answers.com should have grown off of its paltry revenue base by multiples of Aquantive (AQNT) and Google. Well it seems that wasn’t the case as Google grew QoQ by 20% (off of a $1.87 BILLION base) and AQNT grew by 20% QoQ off of a $111M base. Looking at a batch of industry comps, one has to wonder when the “out-of-this-world” growth is going to materialize for Answers.com.

What may be more disconcerting to shareholders of Answers.com than the diminishing growth, gross margin contraction (57% in Q4’06 vs. 63% in Q4’05), lack of cash flows, stretched capitalization, or aggressive analyst estimates, is the egregious stock option issuance and expenses to upper management. Allow me to correct a prior post that stated Answers.com management owns 14% of the company. Per the 10K recently filed, directors and officers owned 11.6% of the company. While this is still respectable, one becomes a bit suspicious of this number when option grants and FAS 123R expenses are considered. Excluding stock-based comp from the Brainboost acquisition (which is a whole ‘nother debacle that cost the company $9.7M for what again?); Answers.com had FAS 123R expenses of $1 million in 2006 for its five executive officers. This expense was roughly 14% of revenues in the year and the 250,000 shares results in over 3% dilution.

But this management team didn’t stop its self-directed options bonanza in 2006, as they disclosed in its 10K under subsequent events that they have already granted themselves another 274,000 shares (~4% dilution) in 2007 at the exercise price of $11.61. Answers.com management is effectively granting the executive suite increased ownership each year at the expense of existing shareholders. And hey why not? Investors and sell-side analysts have obliged the company’s request to pro-forma out stock-based comp expenses. Even though this is a cost of doing business for this start-up company, and a very real and recurring expense as evidenced by the dilution, investor’s are backing this out of earnings numbers. In Q1’07, Answers.com guided Stock-based comp to be between $520,000 and $540,000, a run-rate well above the $1M that was spent in 2006. As a percent of Q1 revenue, per its guidance, this is nineteen percent of revenues! So will it really be a big surprise when they’re profitable in Q1’07 after $530,000 of stock-based comp and $310,000 of amortization from poor acquisitions are excluded?

There are more risks to consider, such as the fact comparing Answers.com to the peer group isn’t apples-to-apples given the fact its “estimates” are untaxed. Slap a statutory tax rate on that $0.76 estimate for the out year, which there is no reason to expect them to earn, and suddenly they earn a fully-taxed $0.46. Currently the stock is 28x that number which sure seems overvalued given the laundry list of issues I have discussed above. And that assumes they actually make the estimates…..

Finally, let us not forget the Israeli discount that should be applied when valuing Answers.com. While there are many tremendous technology companies in Israel, the sad truth is as long as there is the potential for severe conflict in the Middle East, there will always be a “war premium” embedded in the multiples of Israeli companies. With management based in Israel, as well as most of its headcount, it seems absurd that Answers.com isn’t subject to a steep Israeli discount. Investors in Answers.com are complacent, and sadly, when the light does go off, the bids will disappear and the liquidity risk in a name like this will amplify losses.

Unfortunately, good products, and even good companies, often times make lousy investments. I like Answers.com website and find it extremely useful. However, the cold facts make it very hard to understand how this stock is more than $6 or $7 as the inefficiencies get wrung out of the current small cap froth. With a plethora of major risks inherent in its business model, as well as the jaded representation of its financial model, Answers.com should be a show me story, much like Local.com ($46M cap with $14.2M of TTM revs), Aptimus ($25M cap with $15.9M of TTM of revs), or PlanetOut ($65M cap with 69M of TTM sales)…. Not a $143M cap company with $7M of TTM sales.

Ultimately, the market will get this one right and investors will be reminded that the right investment “answer” isn’t always the easiest one for a portfolio to swallow.

Disclosure: Author has a short position in ANSW

ANSW 1-yr chart

Comments

[Derek Rodgers:]

this is extremely interesting. i was involved with these guys in 2005 - 1h'06. while, i too like the product, i quickly realized that we were talking about mousenuts for revenues with a lion-sized market cap. i agree entirely that the stock is a) extremely overvalued (based on what they have done-to-date), or b)simply will grow into their valuation over time. I'm not sure what the answer is, but you make a very good point, several in fact, about the lack of parabolic growth. The other element about the story that was somewhat bothersome is the shareholder base. aside from Royce and trellus, you have shaerholders that are mainly retail - and prone to emotions... which creates high volaitility in the stock. the other point you make - the liquidity is a nightmare. This stock could be 17 or 7 in a month for no company specific reason. I do like management and hope the company does well. However, I think you are spot on and there may be some pain in the process for shareholders.

2007 Mar 27 09:10 AM

[Davis Freeberg:]

I think that you pretty much nailed this one. A very well written piece. There are a few parts where it seems like you go a bit too far, but you do a good job of addressing both the positive and negative developments. Great piece with good critical thought, you raise some very important points.

2007 Mar 27 10:39 AM

[Brian Bianka:]

This is a very thoughtful post. I think what you may be missing being short is the fact certain stocks like Answers.com can trade detatched from fundamentals for long periods of time. Answers.com has clearly done that. There will be a time to short this aggressively, but probably after the first break, on its way from 10 to 7. The other point I'd make is that the sell-side must be overly-bullish with estimates, especially on forward numbers, as a means to justify fresh powder being put to work by institutions in their names. This is especially true in the case of companies like ANSW that will need to access the capital markets. It is also an interetesting to debate the tax rate question. Clearly for those who think this may be a take out, then the tax rate issue is a question because an acquirer would likley have a full tax rate and would adjust ANSW numbers with a tax rate as you have done. However, if they have a tax holiday in perpetuity, then maybe the right way is untaxed. On balance, this is very insightful piece....

2007 Mar 27 11:06 AM

[Mark Martin:]

Mr America, as being short, you must be very concerned because ANSW will soon report turing the corner and showing the profit. While some of your analysis is well orchestrated to make ANSW look bad you just forgot to state that ANSW is growing about 30% Q to Q on compounded basis and they will just show the profit. Even Dave Gentry and his RedChip propaganda had to back off of most of their misleading statements and issue a correction. RedChip sends huge amout of e-mails and news to bash the companies that do not pay them "Visibility fees". What is your modus operandi and are you associated or talking to RedChip? Your statement "Between, two small acquisitions, and operational cash burn, the company has plowed through over half of its cash in one year" implies that ANSW will burn all their cash in 2007. With positive cash flow in 2007 ANSW will not run out of money and their cash position might even improve. All you shorts are trying to push stock at $5 range but if after ANSW shows the profit (and it will) and stock goes to $20 it might become a sad story for shorts. The truth is that ANSW is only two years old start up growing fast, with unique and patented services and features and huge potential. IMO ANSW can easily show in 2007 EPS of $1 and in 2008 EPS of $2. Their direct sales campaign will increase RPM substantially and all that revenues go to bottom line.
Disclosure: Long and waiting for $30 a share.

2007 Mar 27 12:28 PM

[Jackson Ame...:]

Mark,
Thank you for your input and your points are well taken. I have disclosed that I am short ANSW so that should explain why I have chosen to post my point of view here. I also appreciate the feedback that this site provides. To your question about my concern surrounding Answers.com turning the profitability corner, my answer is a resounding “no.” First, I do not believe consensus estimates. Second, for Answers.com to grow the top line, I believe they will need to spend to do so (you point out that direct sales campaigns will increase RPM’s – direct sales people cost money), which will limit their profitability. I think that Answers.com will be CF+, but I also tried to point out that FAS 123R expense is a real cost and extremely significant for ANSW, although it’s not a cash cost. I think that the company is issuing stock to employees, and more lavishly to management, as a substitute for cash comp, which artificially boosts CFO. Further, I am modeling interest income to represent almost 50%+ of their “earnings” in 1H’07 – which surely doesn’t warrant a multiple. Recall, ANSW has ~ 11M shares out, which leads to a $143M market cap, so a few pennies of “pro forma” earnings doesn’t concern me as a short. In fact, I think there are a significant number of shareholders like yourself that believe this “turn” will represent a major catalyst, which seems odd given the fact the company has guided to be CF+ and profitable throughout 2007, and analyst estimates reflect this assumption. It is my opinion that Q1’07 profitability may actually represent a major negative event when the news hits and all of the longs ask themselves “ok, now what?” On a separate note, I would be very curious to know what metrics (queries, RPM’s, and opex) you are using to arrive at your $1.00 of EPS for 2007. Either way, I appreciate the feedback. Our differing opinions are what make the horse race.

2007 Mar 27 07:49 PM

[Mark Martin:]

Jackson,

Here is my simple calculation re EPS of $1. ANSW with some more aggressive PR, marketing, sale and improvements to their Web page can generate $20 million in revenues in 2007. Non-GAAP expenses could be held at $12 million. That leaves $8 million or EPS of $1 a share. I do agre ANSW is undecapitalized and too conservative. Even with the money in the bank, if they put $1 million in promoting their services, marketing and sales, ANSW can easily accelerate their growth from 30% to 50% Q to Q or possibly even to 100%. Unfortunatly, Bob and Bruce are not willing to spent $1 to yield back another $5. That means we will continue to see growth of about 30% Q to Q. Not bad, but they could easily be $100 million in revenue company if they were to follow guys like Bill Gates, Google, Yahoo, and others. If they have dynamic and aggressive leadership like Google has they would be already $50 stock going to $100. Their acqusions and stock options did not help them at all. It badly messed up their financials, but even at growth of 30% Q to Q stock should get to $30 after they show postive cash flow and profit. Bob and Bruce went to seven investors conferences and did not attract a single analyst or institution. Do you have any idea, why not? By the way, how is Dave doing? If ANSW pays him $30,000 can he help to double the price of the stock and help seconadry at $25 a share so ANSW can be much better capitalized? Then you can short ANSW at $50. That way we all win.

2007 Mar 28 11:22 AM

[User 176917:]

Does anyone else think that Answers Tips is cutting edge (or should have been for a long time now) and that everyone private and business would want the convenience of using it???????????????

2008 Apr 11 07:09 PM