Description

Short. Verso (VRSO) was a once-hyped voice-over-IP (VOIP) play that, despite falling 85% from its high of $5.00 in September 2003 to $0.75 today, is still a good short. Although the stock is trading below $1, VRSO has an extremely high market cap of $103 million because of the 136.5 million shares outstanding. I believe this valuation is exorbitant given that the company could soon run out of cash with $11 million left in debt/cash obligations and no value to the equity.

Valuation:
Stock price = $0.75
Shares out (fully diluted) =136.5 M
Market cap = $103M
Cash = $11 M
Debt/cash obligations = $11 M
My 2005E revs = $45 M vs. Consensus 2005E revs = $54 M
My 2005E EPS = ($0.12) vs. Consensus 2005E EPS= ($0.12)
LTM FCF = ($13 M)
My NTM FCF E = ($10 M)
Book Value = $0.25
Tangible Book Value = $0.09
Avg Daily Volume = 2.1 million
Short Position = 1% of float
P/Rev 2005E = 2.3x
P/E 2005E = NM
P/Tang Book = 8.3x

Background

I believe VRSO is an ideal short as it is an overvalued stock with deteriorating fundamentals, run by a CEO intent on destroying shareholder value.

The CEO Steve Odom has created Verso through a hodge podge of acquisitions all loosely related technology-wise. Despite the stated synergies of his many acquisitions, I believe the CEO has used acquisitions with VRSO stock as an excuse to replenish the company’s declining cash levels, and also to create the appearance of top line growth. The consistent dilution to shareholders over time has allowed VRSO to remain afloat despite accumulating a deficit of over $290 million.

Prior to Verso, the CEO had a similar strategy of creating the appearance of revenue growth through acquisitions, while burning through millions. As CEO of World Access (WAXS) from 1994 to 1998 he grew revenues from $6M in 1994 to $152M in 1998 but also accumulated a deficit of over $120 million. Odom stepped down as CEO of WAXS in 1998 but continued as Chairman until 1999. During that time, World Access acquired Resurgens Communications (renamed Cherry Communications), of which Odom was a former director. One month after World Access’s acquisition of Resurgens/Cherry in December 1998 with WAXS stock, WAXS stock tanked on lower than expected earnings for the December 1998 quarter. Odom left as Chairman in June of 1999, walking away with over $17 million in cash from option exercises alone in 1997 and 1998. World Access eventually filed for Chapter 11 in April 2001 and Odom bought NACT out of the WAXS bankruptcy in July 2001. Odom was named CEO of Cereus Technologies, which became Verso Technologies in September 2000.

I believe Verso carries on World Access’ legacy as a complete house of cards. A brief timeline of VRSO’s recent history follows:

September 2000 – Odom is appointed CEO of Cereus Technologies, which becomes Verso Technologies.

November 24, 2000 – VRSO issues 1.4 million shares, 1 million warrants, and $4.5 million in 5-year 7.5% convertible notes to acquire MessageClick, Inc.

November 26, 2001 – VRSO issues 25 million shares to acquire Telemate.Net.

October 2, 2002 – VRSO purchases a 51% interest in Shanghai BeTrue InfoTech Co. for $200,000 in cash and $236,000 worth of VRSO equipment.

February 12, 2003 – VRSO issues $9.8 million in debt to acquire Clarent, which had declining revenues of 40% y/y and 28% q/q at the time of purchase (only learned through careful reading of past Clarent filings and S-1s.)

September 26, 2003 – VRSO issues 18 million shares to acquire MCK Communications, which had declining revenues of 15% y/y and 12% y/y at the time of purchase (only learned through careful reading of past MCK filings and S-1s.)

February 25, 2004 – VRSO issues 12.3 million common shares and options for proceeds of $16.25 million in a private placement.

August 3, 2004 –VRSO reports $11.3 million in revenues for the June quarter, below consensus of $17 million.

October 6, 2004 – VRSO pre-announces September quarter revenue of $11.0-11.3 million, below guidance of $20 million.

December 9, 2004 – VRSO provides update on business, but offers no guidance.

Going Forward?

Clearly VRSO stock has priced in much of the recent bad news. However, I believe there is still more downside as the market for the company’s products continues to deteriorate and management continues to outspend revenue.

Verso’s current product line includes:

To Service Providers:
Clarent Softswitch
Clarent Media Gateway
NACT Prepaid Phone Solution
NACT Gateway

To Enterprises:
NetPerformer VPN Software
Telemate.Net PBX manager
MCK PBX Gateways and Extenders
NetSpective Internet Filter

I estimate VRSO’s legacy solutions, NACT, and Telemate.Net revenues in aggregate will generate $17.8 million in 2004 versus $35.6 million in 2003 and $44.8 million in 2002. These revenues have declined precipitously as NACT Gateway revenue is being cannibalized by Clarent gateway revenue, and as NACT prepaid phone solution revenue disappears from international carriers (the product’s primary market.)

I estimate Clarent revenues will be $21.8 million in 2004 versus $22.9 million in 2003 and $30.6 million in 2002. Although relatively stable recently, revenue from Clarent’s VOIP-based softswitch is clearly not benefiting from the growth in VOIP services. Verso cannot, and has not been able to profitably compete with the many contenders in the softswitch market such as Nortel, Lucent/Telica, Sonus, and VocalTech. Channel checks indicate Clarent is barely present in this market.

I estimate MCK revenues will be $10.8 million in 2004 versus $11.8 million in 2003 and $15.8 million in 2002. MCK offers an interim solution for the transition of TDM to VOIP-based based PBXs that will be able to maintain current revenue levels, at best.

It will be very challenging for VRSO to maintain its current quarterly revenue run rate of $11.2 million given the fast decline in its legacy Verso and NACT revenues and barely stable Clarent and MCK revenues. Even if Verso can achieve revenue stability in 2005 with revenues of $45 million, this level would not offset expenses of approximately $54 million. On Verso’s most recent conference call management announced that it had fired 60 people, which will result in annualized savings of $5.2 million. This is not nearly enough of a cut in expenses, especially as the company also intends to make improvements to sales and marketing. I estimate the company will burn approximately $2.0 to $4.0 million per quarter going forward, taking into account working capital and capex needs. Given that the company only has $10 million in cash, I believe Verso will soon be in dire need of cash.

Verso has already recently raised money through an offering, and it may be difficult for the company, after missing earnings estimates three out of the last four quarters, and having 3 analysts drop coverage, to raise any more. While the company may be successful in yet again issuing more stock for cash, at $0.75 this issuance will be extremely dilutive to shareholders.

In addition, although the company recently hired former Picture-tel executive Lewis Jaffe as President and COO to turn Verso around, I believe there is little Mr. Jaffe can do to stop the cash burn. While Mr. Jaffe may encourage the sale of some of Verso’s assets, there is little tangible value left as the company primarily leases its property.

Furthermore, Verso, in addition to its operating cash needs, which include $16 million in operating lease payments over the next 5 years, has $4.5 million in convertible notes due in November 2005, $3.5 million in accrued costs due over the next two years from the MCK acquisition, and $3 million of notes payable due in February 2008.

Verso may also face de-listing by Nasdaq. On November 11, 2004 Nasdaq notified the Company that it has until May 10, 2005 to trade above $1.00 per share for a minimum of 10 consecutive business days. If compliance is not met by May 10th and Verso is not eligible for an additional compliance period, then Nasdaq will notify the Company that its common stock will be delisted.

In conclusion, I believe VRSO is an ideal short as it is an overvalued stock with deteriorating fundamentals, run by a management team intent on destroying shareholder value. There are several catalysts to help the short along including many more potential revenue and earnings misses (versus analyst expectations), Nasdaq de-listing, a cash crunch, and upcoming debt payments, most notably a $4.5 million convertible note due November 22, 2005.

Catalyst

Runs out of cash, dilutive offering and/or acquisition, revenue and/or earnings miss, Nasdaq de-listing, missing scheduled debt payments.