The Warrants

A Look at Some More E-mail

In the spirit of last month's company profile, we'd like to use an e-mail correspondence as a vehicle for clarifying a number of the subtler aspects of warrant investing. To begin...

What I would like to know is if you have any figure that you are fairly confident of in terms of the percentage of warrants that are extended and how long before expiration that extension is anounced. I would think if the percentage is high and you could pick up expiring warrants at a low price and then sell them as soon as they are extended the profit potential might be quite large - have you thought of trying this approach?

My response (your webmaster's)...

I've put a fair amount of thought into it. I always make a mental note of how far from the expiration date a warrant gets extended. My take: there's no solid pattern here. I've seen warrants get extended with just a day or two to go before expiration, and I've seen warrants get extended 2 years before the expiration date. Most commonly, a warrant gets extended between 1 and 3 months before expiration (my own subjective observation).

About 70% of the warrants that are trading out-of-the-money get extended, if the underlying companies don't fade into oblivion first.

Just to be perfectly clear, "oblivion" would include bankruptcies, out-of-the-money takeovers, delistings, and situations where the warrants are so ludicrously out-of-the-money that there's really no hope that the warrants could ever be exercised.

The problem is this...insiders know whether a warrant will get extended or not. Thus a warrant that is about to get extended might be ridiculously overvalued on a Black-Scholes basis...but then, following the extension, you find that the warrant was actually fairly-valued if you had known that the warrant was about to get a new lease on life. So it's actually not all that common to see huge moves in warrants the day the extension is announced.

Nevertheless, it is useful to understand that a warrant that has been extended once or more is certainly more likely to get extended again than a warrant that has never been extended.

Of course, we can't definitively prove that insiders tend to take unfair advantage of their knowledge of the likelihood of an extension. However, as mentioned above, the rarity of major moves in a warrant's price after the extension has been announced does seem odd. It seems that the market has usually factored the likelihood of an extension into the warrant's price well before the actual extension announcement has been released.

A related question from the same subscriber...

Do insiders have to declare purchases of warrants the way they have to show purchases of stock or do they get around this somehow? I would think insider activity in warrant purchases or sales would be a major tip off on extension or not.

My response...

Great question. I actually put that question to the folks at "The Insiders" (one of the newsletters that tracks that stuff). According to them, insiders do have to file with the SEC for warrant trades. That's really not surprising.

About a year ago, I thought I might try to build on the stockwarrants.com empire (ha, ha, ha) by constructing a web site that focuses on insider trading. In doing my research, I found that one company has contracted with the SEC to be the sole provider and tabulator of insider data. All other services must pay this service for the data. Unfortunately, the "primary" provider of the data does not tabulate the data in such a way that there's any discrimination between trades of common stock and warrants.

Now there's actually quite a good insider trading site on the web: http://www.insidertrader.com .

Now, if you go to insidertrader.com, you'll notice that there's a box in which you can type a stock symbol and request all the available insider trading information for that particular stock. Just coincidentally, we entered "aasi" (the stock symbol for Advanced Aerodynamics, a recently profiled company). While the report that we received did not discriminate between warrants and common stock, we did notice that several transactions were made last February at a price of $1.09...the common stock never traded anywhere near $1.09 back then, but the Class A warrants certainly did fall into this price range at the time. So it does seem that diligent investors can make some attempt to garner information on the insider trading of stock warrants.

By the way, the insider trading report on aasi shows that there were only several thousand shares traded at $1.09. Further, these trades were actually sales (so much for insider prescience...the warrants have performed nicely since).

The Company

Dualstar, through a plethora of subsidiaries, provides a number of services relating to the installation of various mid-tech/hi-tech systems in office buildings. These services include, but are not limited to, the installation of computer network systems, high-speed internet lines, air-conditioning and heating systems, security systems, intercoms, and sophisticated "building automation" systems that control a building's electrical consumption. Another subsidiary is focused on the retrofitting of equipment that uses CFC refrigerants.

Depending on the particular subsidiary, Dualstar's contracting services operate on both long-term contractual and short term pay-per-service-request basis. The company's efforts are focused nearly entirely in the New York Tri-State area.

If you look at the company's chart for the last couple of months, you'll notice a sharp rise in the stock's price in May. This rise is connected to the signing of an agreement with Teleport Communications (Nasdaq: TCGI), a major supplier of local telecommunications services and equipment. Via the agreement, Dualstar will contract for the installation of high-speed telephone and internet lines using a new sort of cable technology (RADSL). While the company offers only scant indication as to the ultimate dollar impact of the agreement on Dualstar's future, the deal is particularly intriguing when one considers that TCG is in the process of being acquired by AT&T. Essentially, Dualstar has an "in" with AT&T.

Having taken a number of significant writeoffs related to the acquisition of its various subsidiaries, Dualstar's earnings reports for the last few years have been quite dismal. However, the last three quarters have actually been profitable...these profits do not include any large one-time gains in revenues, giving us reason to believe that long-term profitability might actually be in the cards for this company. The company certainly does participate in a number of areas (e.g. retrofitting high rise buildings with high-speed internet lines) that could experience significant growth over the next few years. Potential investors should bear in mind that the warrants do have a relatively short expiration.

Some Numbers

Shortly after the company's February 1995 IPO, the common stock traded as high as $11.00 and the warrants as high as $8.50. Thereafter, as is so often the case, the stock dropped precipitously as the reality of significant quarterly losses sunk in.

For the quarters ended 12/31/97, 9/30/97, and 3/31/97, the company lost $.20, $.01, and $.42 per share. The three most recent quarters, however, have seen gains of $.03, $.05, and $.01...nothing spectacular, but it's nice to see that Dualstar is actually capable of making a buck without the benefit of any significant one-time gains.

Revenue gains have been steady, if not spectacular, over the last few years...$73,600,000 in fiscal 1997 vs. $66,000,000 in fiscal 1996 vs. $65,100,000 in fiscal 1995. In the last year, the company has added quite a few employees (there are now over 300). Further, the company has indicated that it is not at all opposed to ridding itself of several unprofitable subsidiaries...it would appear that we shouldn't expect that future revenues would be entirely predictable.

Historically, a large chunk of Dualstar's revenues have depended on a limited number of customers. For the year ended 6/30/96, four customers accounted for 72% of the company's revenues. For the year ended 6/30/97, the figure dropped to 61%.

The company has about $21,000,000 in both current assets and liabilities. We wish the current ratio were higher, but then, such ratios are not unusual in these sorts of contracting businesses.

The Warrants

At current levels, the warrants seem quite attractive...even with the call provision figured in, the warrants out-leverage the common stock by better than a threefold margin (e.g. a six-fold increase in the common stock from current levels will result in a minimal twenty-fold increase in the warrants). This leverage is quite good as warrants go, though some of this leverage must be attributed to the relatively short expiration. The company remains mum as to the likelihood of an eventual extension if the warrants were to trade out-of-the-money as expiration nears. Given the company's bent for acquisitions, however, we wouldn't be surprised to see an extension in such a case.

We'll add the warrants to our model portfolio at the current ask price ($.25).

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