SmartForce takes decision for long term

It took CBT, the educational software company, a year to breed renewed confidence into the share price; it did this with a senior management reshuffle, and with a steady, well crafted, recovery programme.

Yet it took a mere one-hour conference call to analysts in the US, to vaporise most of this. Curiously it managed this questionable feat by announcing a changed strategy to have its courses more inter-active through the Internet, and a changed name - SmartForce. The result: a massive share sell-off which reduced the value of the company by almost $600 million (€560 million).

If the slump in the share price, from $27.25 to $16.62, had been in a tight market, it might not have appeared so grim. But 7.5 million shares, out of the 55 million in issue, changed hands on Tuesday, representing 13.6 per cent of the total. This was followed by 4.27 million on Wednesday, 2.74 million on Thursday and 2.54 million on Friday. That means that around one-third of the group's shareholders abandoned it.

Markets, of course, don't like surprises. SmartForce's new strategy must have upset many analysts. They had been warming to the company following the debacle in 1997 which saw the shares collapse from $63.87 to $6.72. And the fact that founder Mr Bill McCabe had sold $40 million worth of CBT shares prior to the collapse didn't help sentiment though he was then a non-executive director. Also, analysts were looking for profits of some $36 million in 2000. Instead, the new strategy will instead push it into the red.

The market seems to have missed two points. First, the results for the third quarter - pre-tax profit more than doubled from $3.35 million to $7.2 million - were as good as the best estimates. All the underlying financial ratios were moving in the right direction and it had built up more than $100 million cash. Second, the new strategy of transferring its business to the Inter net is designed to substantially enlarge its business and produce much higher profits in the future. Granted, this means some financial pain over the short-term. It could have ducked this by continuing with its existing strategy and grown the business by 25 per cent to 30 per cent per annum. Instead, the new strategy has the potential to grow its business by 50 per cent per annum.

The plan runs like this. It wants to invest $50 million in its Internet infrastructure and in building its new brand. Smart Force said it planned to "redefine the learning industry by unveiling a first-of-its-kind, fully integrated, Internet-based e-Learning solution". As it will be providing access to an Internet environment rather than selling software licences, revenue under the new agreements will be recognised over the term of the agreements rather than annually in advance, thereby reducing revenue substantially in 2000.

But if SmartForce is right about its projections, then the first profits should flow through in the last quarter of 2000, and the real benefits should start to come through thereafter. CBT had already been moving into the Internet but SmartForce has already got a good kicker to the new business with two large contracts: $25 million from Unisys and a new long-term $11 million agreement with Computer Sciences Corporation. And significantly, a pilot scheme of new e-learning has been successful, according to the company.

The transition has been welcomed by a number of analysts. IDC analyst Ellen Julian said "what SmartForce is doing is delivering what customers are asking for". Mr Brandon Hall, author of The Web-based Training Cookbook described it as a "smart transition". Goldman Sachs (it has a target share price of $30) and Thomas Weisel Partners Elliott (its price range is $27 to $33) are optimistic that the strategy will work.

While almost one-third of the group's shareholders have abandoned it, it is also true that one-third of its shareholders are new. It was inevitable that the shareholder base would change and this trend is likely to continue. Indeed, the shares had recovered to $20 1/16 by Friday. Still it is quite strange that a market which thought the shares were worth $27.25 before an announcement, designed to enhance its value, are now worth less.

Quite obviously as the shares will have no earnings stream next year, they cannot be valued this way. The company is expected to give data on the number of subscribers, the traffic and retentions. Investors will have to get used to valuing it in a different way, e.g. like multiples of estimated revenue as is used on other web-based training groups. If SmartForce's revenue falls to $150 million in 2000 (down from an estimated $190 million in 1999) and recovers to $250 million in 2001, SmartForce's shares are on a prospective multiple of 7.4 for 2000 and 4.4 for 2001. Goldman Sachs reckons that "webify" business processing groups have a range of 10 to 15.

This indicates the upside potential for SmartForce. The company was, of course, right to take this courageous step to keep its business at the cutting edge; those who do not move to web-based learning are likely to see both market shares and margins contract.

It is, of course, not without its risks. And SmartForce will have to ensure that the contents on its site are enticing, reliable and well ahead of any competition, for the two target areas: business to business, and business to consumer.