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No. of Recommendations: 12
Please note this is one of my first attempts, and I'm not that good at this. I hope you enjoy it, but if I'm way off in places feel free to let me know.

I have read “The Little Book That Beats The Market” and have gone to the web site to see the types of companies the formula spits out. CALL in particular was interesting to me, so I decided to look into the company to see just how good a value it is today.

The current market cap of the company is ninety-eight million, and they have sixty-one million dollars in cash and short-term investments. They have less than five million in liabilities, so the actual value placed on the business by the market is forty-two million dollars.

The reason the market has become so pessimistic about the company has to do with shifting market conditions for the services they provide. Currently a majority of their sales and profits come from landline-based dial up Internet add-ons. (Not a great place to be right now, obviously!). Based on my look at their product they have a very interesting and possibly useful array of software utilities which I talk about at the end of this evaluation.

It's not their fault the market is moving away from those services. To make up for this loss of revenue and earnings (as of September 30 their interim earnings were expected to be .04 for the quarter, down from .17 a year before, a decline of 69%) they are trying to shift their product offerings, the core of which is the add-on software, to cell phones. It should be noted that this shifting is not the only source of their pain; SG&A expenses are was up as a percentage of sales from last year. They are trying two different things to accomplish cell phone penetration: 1) Partner with 3rd parties to piggyback their services onto existing offerings and 2) Market and sell their own brand of cell phones including their software as a value add. So far they haven't sold a lot of these, and time will tell if they will or not be able to gain traction.

Another reason for short term indigestion from the market; November 2nd they announced a negative surprise of earnings of .04 verse expectations of .07, a miss of 42.9%. Oops. This still gives them earnings of 3.29 Million a year if they don't continue to trend downwards. With a market cap of 42 Million that gives us a P/E of 12.76, not that great with all the risk built in. But if they get back to earnings of even .07 quarterly that gives us yearly earnings of 5.7 million, which gives us a P/E of 7.36, which is very cheap. If they can return to their glory days of earning .11 per quarter (as they did in march of 05) or .20 (as they did in Dec 04) they are a screaming buy. In the March example we would have a P/E of 4.6, in the December example a P/E of 2.5. In addition to this they don't seem afraid of dilution:

2005 2004

Basic 20,374 6,540

Diluted 21,160 17,365

I forget exactly what that dilution came from but I believe it was preferred stock or something similar. On their cash flow statement they recognize in June of 05 a loss from investing activities of 33 Million, but then a gain of 37 Million on sale purchase of stock. I'm not experienced enough with a cash flow statement to know exactly what this means, but it looks like however they did this they came out about 4 million ahead in cash, but diluted the hell out of their shares. But even without this dilution the share count rose more than 20%, due to options? I don't know I didn't find that information. If someone knows where to find that it would be appreciated.

I'm not sure I have much faith in the management due to the dilution here but I don't care if they are cheap enough. The question is, can they climb their way back?

Analysts seem to think they will grow by 15%, but these are the same guys who thought this company was going to earn .13 in Dec 04 and they actually came in at .20. So I can't take a lot of faith in them knowing where this business will go, especially with all the unknowns out there. So I want to look into the things they are doing to turn this thing around. One recent development:

18-Nov-2005

CallWave Inc. today announced that John M. Greathouse resigned from his position as Executive Vice President of Sales and Business Development, effective November 11, 2005. Mr. Greathouse is assuming a consulting role with the Company. Josh Fraser, Vice President of Business Development, will be handling Mr. Greathouse's responsibilities, reporting to Chief Executive Officer David F. Hofstatter.

On December 14, 2005, CallWave, Inc. (the “Company”) entered into an Employment Agreement (the “Employment Agreement”) with Joshua Fraser effective as of December 13, 2005. The Employment Agreement provides for employment as Vice President of Business Development for a three-year term.

The terms of the Employment Agreement provide that the Company will pay to Mr. Fraser a base salary of $185,000, an annual cash bonus of up to 225% of his base salary, and certain other benefits. Pursuant to the employment agreement, Mr. Fraser shall also receive an incentive stock option for the purchase of 100,000 shares of the Company's common stock, exercisable at fair market value, which will vest over a two-year period, with 25% of the shares subject to the option vesting after six (6) months of continuous employment following the grant date, and one-twenty-fourth (1/24 th ) of the shares subject to the option vesting monthly over the next 18 months. The Employment Agreement further provides that if Mr. Fraser's employment is terminated by the Company other than for misconduct or disability, or if he resigns for good reason, then he will be entitled to a severance pay package of up to six (6) months (3 months in the event of resignation for good reason) of his base salary and bonus, 24 months' acceleration in the vesting of the above-described option, plus continuation in the Company's healthcare plan for up to one year at Company expense. If, within twelve (12) months following a change of control, Mr. Fraser's employment is terminated by the Company other than for misconduct or disability or if he resigns for good reason, then he will be entitled to a severance pay package of up to twelve (12) months of his base salary and bonus, 100% acceleration in the vesting of the above-described option, plus continuation in the Company's healthcare plan for up to one year at Company expense. No severance pay is payable if Mr. Fraser voluntarily terminates his employment with the Company.

So this looks like the Executive Vice President of Sales and Business Development quit, then the guy under him in the food chain took his position, while he stays on in a consulting role. I can't see anything to be excited about here. Plus he's getting paid potentially 600K plus options while the company could be making as little as 3 million a year or less moving forward. To me it seems irresponsible to pay someone this much when the company isn't making a lot, but maybe they see brighter things in their future and aren't that worried about the money. I'm definitely not as optimistic as they are.

Also I don't understand the following line: Mr. Fraser shall also receive an incentive stock option for the purchase of 100,000 shares of the Company's common stock, exercisable at fair market value, which will vest over a two-year period. What do they mean by “exercisable at fair market value?” Does that mean they are just giving him that many shares for free, or does he have some kind of cost basis? Who determines fair market value? If they just mean they are giving him free shares at present market price that means he will be paid another $500K over the next two years in options. With a company possibly making as little as they are now this is a ton of money to be giving to a guy to run the sales team. The balancing number to look at there is that according to yahoo insides still own 50% plus of the company, so they must have at least some interest in benefiting the shareholders.

Moving on to why earnings declined so much specifically:

BRIEF: For the three months ended 30 September 2005, Callwave Inc.'s revenues decreased 4% to $10.6M. Net income decreased 68% to $932K. Revenues reflect a decrease in revenue due to a fall in
the number of subscribers. Net income reflects higher cost of sales, higher general & administrative expenses and an inclusion of $243K impairment charges. Callwave provides a software-based service
for subscribers to bridge calls.

More specifically:

General and administrative. General and administrative expenses were $2,182,000, or 21% of revenues for the three months ended September 30, 2005, compared to $1,276,000, or 12% of revenues, for the three months ended September 30, 2004, an increase of $906,000, or 71%. The increase in general and administrative expenses was due primarily to an increase in legal, bad debt, insurance, investor relations, employee-related and Board of Directors costs. Specifically, directors & officers liability insurance costs increased $171,000, legal costs increased $150,000 and bad debts expense increased $350,000 in the three months ended September 30, 2005 as compared to the same period in 2004. Bad debts expense for the three months ended September 30, 2004, reflected the benefit of a reduced estimate of bad debts expense.

Net income. Net income was $932,000 for the three months ended September 30, 2005, compared to $2,901,000 for the three months ended September 30, 2004, a decrease of $1,969,000 or 68%. This decrease in net income was primarily the result of an increase in cost of sales related to our entry into the mobile phone market, increased general and administrative expenses related to operating as a public company and a tax provision of $633,000 in the three months ended September 30, 2005, an increase of 699,000 over the same period in 2004. During the three months ended September 30, 2005, our revenues decreased by $473,000, while our cost of sales increased by $559,000 and operating expenses increased by $690,000. Our net margin was 9% and 26% for the three months ended September 30, 2005 and 2004, respectively.

Wow, so we have taxes this year when they had a credit last year, decreasing revenues, higher administrative costs, legal costs, lots of bad debt etc. I'm not really seeing how this is going to be a great story moving forward. For me there is just too much bad happening here, and no clear explanation on how it's going to get better. Here are some of the things management will tell you about their risk moving forward:

Because we are unable to predict with precision the rate at which consumers will subscribe for our mobile services, our results of operations may be correspondingly less predictable, our stock price therefore may be more volatile, and our stockholders may suffer losses.

For the past several years we have marketed our landline services directly to consumers and have assembled a substantial amount of data that allowed us to predict our subscriber counts, revenues, and profits with some reliability. As our business increasingly emphasizes the delivery of mobile services, however, we will be operating in a new market segment and offering to potential customers new services that have not been marketed or sold by us or any other company. As a result, we have little historical data with which to predict with any precision the rate at which our services will be accepted by consumers or the prices at which consumers may be willing to subscribe for those services. Consequently, we may experience significantly greater swings in our revenues and profitability than in the past, our stock price may become increasingly volatile, and our stockholders may realize losses in the value of their shares.

Our executive officers, directors and 5% stockholders together beneficially own approximately 63.6% of our common stock

They have hope they will turn it around but I don't see any clear-cut reason why they will do moving forward. They might, they have done well before. But how do we know that it will happen?

Beyond the numbers:

From reading research reports and going through their web site my understanding of the company's services is this. They depended on landline services mostly up until recently, namely fax to email and messaging through a home user's speakers when they are online. But it looks like this feature only works for dial up, which is why this business is slowly fading away. To replace this feature they are now giving directly and trying to partner with 3rd parties to help distribute their cell phone software. The basic version of this software is free; a more advanced version including unlimited call length is $4 a month. This software does four things that I found interesting and possibly fruitful for Callwave:

Call Screening: You can have someone identify him or herself before you answer the phone by speaking their name, which is then played to you.

Call Transfer: Transfer calls to a second line. So if you're at work you can have them forward the calls to your work phone etc.

Voicemail to Email: They record your voice mail and I'm assuming send it in an MP3 file to your email.

Take Cell Phone Calls Online: Turn your phone off and have your calls sent and connected over the Internet.
They are also starting to sell prepaid cell phones that have this functionality built into them. Time will tell how they do. This could be an interesting turn around story later, but I feel right now you are not buying with enough knowledge to make a good decision. The company is in shambles according to the stock price, and a turn around will be attempted. But right now the only turn around story is what they are going to do, not what they have done. I think it is also reasonable to factor in risk for lack of a moat, I believe any company seeing profitability here with a good software team could do what they do.

Today we'll see based on their most recent earnings release after hours if they have made any progress, and I will try and post notes. Please be aware my writing is mostly for the benefit of learning, and my opinions and facts should not be relied upon to make buying decisions. Any feedback or help in areas I looked at incorrectly would be appreciated.

Thanks for reading.

Jeremy
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