Mercury and Comverse: Strategic Fall to The Pink Sheets (MERQ, CMVT)

Includes: CMVT, MERQ
by: Shlomo Greenberg

Many people recommend Mercury Interactive Corp. (MERQ.PK) as an interesting company for investment. Earlier this week, it got another push in this direction from Forrester Research (Nasdaq: FORR), which said with absolute assurance that Mercury has the best software testing tools, and the best service - well ahead of companies such as IBM (NYSE:IBM).

Forrester wrote that Mercury’s dominance in the software testing market was unchallenged and that its solutions had the highest scores in every category.

Forrester asserts that investment in various testing applications is growing, so it examined the sector leaders. The results are quite impressive as far as Mercury is concerned.

OK, so Mercury is the world’s leading software testing company. Everyone knew that even before its share collapsed late last year. What has happened since that collapse, which was caused by circumstances unrelated to the company’s business, but to do with the personal business of then chairman and CEO Amnon Landan, could teach us all a lot of things about the behavior of Wall Street investors, compared with behavior on Main Street.

I have the feeling that the story is repeating itself at Comverse Technology Inc. (Nasdaq: CMVT), which is why I see in the plunge in Comverse’s share as much of a buy opportunity as was the case at Mercury earlier.

The story of Mercury over the past year is as follows: Before its fall, the company was considered one of the analysts’ favorites, and was one of the most covered Israeli shares on Wall Street. Together with Comverse, Check Point Software Technologies Ltd. (Nasdaq: CHKP), and Amdocs Ltd. (NYSE: DOX), Mercury had a reserved place in every investment portfolio that included Israeli technology shares. This was not only because of the excellent results that the company presented every quarter, but also because of the near-mystical relationship, that only Wall Street can create, with its founder Aryeh Finegold and his successor Landan. Analysts loved both men. This was a company that was as transparent as could be from the first day it sought to raise money from the public.

In early November 2005, confidence in Mercury was shaken, when it was learned that an investigation was underway into the company’s options grants to its executives. The company’s investigation committee announced that between 1995 and 2002 there were 49 cases of backdating of options granted to executives, which guaranteed them large profits when the options were exercised.

What emerges from the scandals at Mercury, Comverse, and other companies? After all, it’s not possible that everyone involved was blind. Rather, it seems case that no one cared.

But that is not the point that I want to emphasize in the case of Mercury. I want to stress the lesson that should be learned from the outcome. The case tells us that a new situation has been created on Wall Street, and when speculators dominate the market, it’s better for a company like Mercury or Comverse to drop to the Pink Sheets. The Pink Sheets, which companies that were once ashamed to go near, is now a refuge for good companies whose managers went astray. It seems to me that it’s worthwhile for companies like Mercury and Comverse to drop to the Pink Sheets, on the pretext that this is for the good of the shareholders.

What exactly are the Pink Sheets? It is the ultimate market for radical capitalists. It was created to allow shares traded over the counter in a place where they can show prices to investors and provide financial information. This is an exchange where the rules are no different from the rules for hedge funds, rules that are slack, to put it mildly. Once, when a company fell to the Pink Sheets for one reason or another, serious investors and institutions tended to steer clear.

Let us now look at the changes in investment behavior in recent years, changes that basically mean that it’s better to be listed in the Pink Sheets, where no one bothers you, and it makes no difference to a company’s business anyway. In general, falling to the Pink Sheets, once considered a great shame, is now part of a strategy.

Rather than fight to keep its listing on Nasdaq, it was worthwhile for Mercury to drop quietly to the Pink Sheets for a year or two, and then return to Nasdaq with a new offering, because a long period in the Pink Sheets means that investment institutions tend not to invest in the company.

Mercury’s demotion to the Pink Sheets came after a number of events that drove the share down from $40 in early July 2005 to $23 in late October. What exactly happened during those four months? The slide began when the company announced in early July that there was a problem both with its guidance and its past results. The company said it would have to review its results for the preceding several years, and that there were problems with the options grants, which it would solve with the help of a special committee set up for this purpose.

Although problems began on Main Street, Wall Street ignored them and Mercury’s share even rose. The share dipped slightly, but then Morgan Stanley software analyst Ross MacMillan boosted the share back to $40 two weeks later on July 25, when he said that its fall to $28 was an overreaction.

Another two weeks passed, and Mercury announced that it had no choice but to publish revised financial reports for the preceding years. Naturally, the question arose whether the company would manage to file reports with Nasdaq on time. In other words, in early August 2005, investors realized that dark clouds hung over Mercury. At that point, please note, the problems from Main Street were also on the table. But what happened during the subsequent period on Wall Street? After falling 25% between early July and early October, Mercury’s share suddenly shot up in the second week of October. What happened between July and the end of September? I went over every announcement published at the time, and everything was above board and on the table.

Since Mercury was not a share that I regularly monitored, I was wise in hindsight, but why didn’t all the analysts spot what was about to happen? Why did Ross MacMillan say in late July that the share traded at below its real value? Anyone reading the company’s announcements between early July and the share’s collapse in late November could not but wonder why the analysts didn’t downgrade the share.

The answer is simple. The analysts continued to recommend Mercury even when Landan and the company’s CFO resigned, even when it was clear that the company would not meet Nasdaq requirements and would be delisted, and even when the options scandal surfaced. This was simply because these events had no effect on Main Street, and Mercury continued to mark up sales and pursued business as usual for the same reason that Forrester Research cited today. Mercury has the best product, the best service, and so on. The analysts had no real reason to downgrade their recommendations.

So what happened on November 4, 2005? Mercury’s share plummeted 35% to $22.60. Why? Because of the so-called discovery that Landan was involved in the options scandal, a discovery that had been known since July, four months earlier. Mercury fell to the Pink Sheets only in January 2006, and its share began to climb back from its low point of $22. The share is now traded at $35, close to its price before the collapse. What does all this mean? It tells me that something quite simple: Day traders dominate the stock market.

Back to Comverse

Now Comverse is going down the same road. On March 13, 2006, its share reached a year-long peak of $29.30. The next day it plummeted 17% to $24, after the company announced that it had established a special committee to examine stock option grants. No analyst recommended selling the share at the time. This month, too, an absolute majority of analysts give the share a “Buy” recommendation.

So why did the share fall 18% over the past two days? This is what CBS Marketwatch had to say: “Comverse Technology fell again, down 4%, a day after saying it would not be able to file a quarterly report with US regulators until it completes an ongoing probe of stock-option grants.”

In other words, if one looks at the big picture, Comverse has lost half its value since early July because of an inquiry that is still unofficial, and even though analysts praise the company’s performance. In fact, the fall was caused by neither business nor performance flaws, but because of an investigation, and because it’s now clear to everyone that Comverse is leaving Nasdaq and following in the steps of its colleague, Mercury, to the Pink Sheets. This is exactly what happened to Mercury, because Comverse as organized by former chairman and CEO Kobi Alexander up to now, can grow and lead on Main Street even without him, in the same way that Mercury demonstrates that Landan was no longer required to lead it.

Is it worth buying Comverse at $19.70? If you believe the analysts, then yes, because they all give it a “Buy” recommendation at much higher target prices. I think that in view of what happened over the past few quarters, Comverse is definitely worth buying at this price, but don’t be surprised if day traders hit it hard again after the company falls to the Pink Sheets. So please don’t rush.

Published by Globes [online], Israel business news - - on June 14, 2006
© Copyright of Globes Publisher Itonut (1983) Ltd. 2006