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Take a Pass on Applied Digital

TSC Investment Team

There are a lot of great stock plays in the Under $10 space that we examine every day, and we are always on the look out for new names that bring value to our model portfolio. But from time to time, our search for the next big winner uncovers a stock that could destroy your performance, and bring you a lot of heartache along with it.

We have found one of these potential disaster stocks in Applied Digital Solutions (ADSX Quote), and we would be sellers of the stock here at $6.88 a share, near its 52-week high.

Applied Digital, through its basket of acquired subsidiaries, which includes publicly traded Digital Angel (DOC Quote), markets advanced security products that use radio-frequency identification, or RFID, and global positioning satellite systems, or GPS. Many of Applied Digital's products are used to store and deliver information that is used to monitor and protect wildlife and our food supply, among other applications. In addition, its voice, video and data networks are used to provide secure communications between government offices.

The company, though, recently gained notoriety for one of its newer business ventures. In October the Food and Drug Administration approved the company's implantable radio- frequency identification microchip for human use. The device, called VeriChip, was acquired through a licensing agreement with Digital Angel that runs through 2013. Only the size of a grain of rice, VeriChip is implanted under your skin and contains an ID number that is used to access your medical history, including possible drug interactions, diseases or anything that could determine the way a doctor treats unconscious patients who are unable to provide any of their own information.

VeriChip is cutting-edge technology that has the potential to save lives and decrease the critical time needed for doctors to determine a course of treatment in life- threatening situations.

But we believe other factors need to be considered besides the technology when putting money at risk. The chip's practical usefulness, for one, along with Applied Digital's poor operating performance record and the societal impediments in its path, do little to instill confidence and makes us want to stay clear of this story for now.

After months of languishing near the $2 level thanks to a reverse split, Applied Digital's shares have received a big bump from VeriChip's recent approval by the FDA. The company's shares, which barely traded prior to the announcement, have gained some 160% in less than three months, with millions of shares changing hands daily. Applied Digital is being valued at $303 million by the market, a number that implies lofty expectations.

The trouble is that Applied Digital generates most of its revenue from the sale of voice, video and data networks, not RFID tags, and the human-implantable chip market is unquantifiable at this time and may never have a meaningful impact on the top line. Of Applied Digital's $92 million in revenue in 2003, less than half can be attributed to its tagging business, and that was from its role in tagging animals to monitor things like food safety and the environment for customers like the U.S. Army.

Applied Digital didn't become an RFID play overnight. The company was founded in 1993 and has grown through more than 50 acquisitions. This "roll-up" strategy catapulted the company's sales, which reached their peak in the white- hot e-business market in the late 1990s. Back then, Applied Digital was providing network technology for the government and generating $300 million in sales a year. Like most tech companies, though, Applied Digital saw its sales fizzle, to under $100 million in 2003. To make up for the sales shortfall, Applied Digital racked up debt in the form of a loan from IBM (IBM Quote). In June of that year, a new management team took the company through a painful restructuring to help it avoid Chapter 11 bankruptcy, and found the company a new hot market to exploit thanks to its acquisitions with its RFID business.

To raise cash to fund its new RFID ventures -- including a more recent acquisition of eXI Wireless that has a product to monitor patient wandering and infant protection and location systems -- Applied Digital recently pulled off a $9 million private placement that brought its net cash number to more than $15 million, based on our calculation. The shares were bought by asset management firm Satellite Strategic Finance Associates, which has been its largest investor over the last year, though it is listed as a net seller of 506,000 shares in a filing at the end of September. We phoned Satellite to ask about its interest in Applied Digital, but the money management firm declined to comment.

Another troubling issue is Applied Digital's management. The group, which constantly promotes its stock with bullish press releases about its future and present business, doesn't seem to have enough confidence in their abilities to own many shares in their own company. The company's CEO, Scott Silverman, has less than a 1% stake in Applied Digital, and he is the largest shareholder on the management team. He is well taken care of by the board of directors, though, which approved his $1.67 million salary in 2003, despite the company's continued weak operating results.

Applied Digital also has to deal with the Big Brother issues that come with invasive technologies that allow others to view personal information electronically. The company's chips contain sensitive and personal information, which carries the potential of identity theft. These issues are generally overcome when a technology could really improve the standard of living, but it is just another bump in the road for this first-to-market company to overcome.

We are also struck by the lack of coverage for the company on Wall Street. Not a single analyst covers this stock. Normally this would serve as a catalyst and would allow us to take a position ahead of new coverage and institutional demand for the stock. But in Applied Digital's case, we believe it signals more a lack of confidence in management and an unwillingness to get behind the story given the company's spotty track record.

Normally, we would hesitate recommending selling a low- dollar stock with a lot of momentum due to the volatility involved with speculative-concept investments like Applied Digital's. Just look at the move Mace Security (MACE Quote) made earlier this year. Mace, a car wash turned homeland security company, in April ran to $14 a share from $2 a share only to have insiders sell boatloads of stock and send its shares back to $5 today. But the fuel for big runs like that, usually a large short interest or daily trading volumes of fewer than 100,000 shares, is not present here with Applied Digital. Only 6% of the float is short, and that can be covered in one day, based on the stock's recent trading surge. The risk/reward is skewed against the longs here.

To Applied Digital's credit, its sales have slowly rebounded this year, though its operating cash flows have deteriorated on a year-over-year basis for the first nine months of 2004. Management has also signed some interesting supplier deals that will help it bring VeriChip to the masses. But this story hinges on the tagging of human beings, and we don't expect that to be a big market anytime soon. When we overlay the uncertainties for its product with its confusing corporate structure and acquisitive nature, we believe the best way to play Applied Digital is to sell now at the stock's high.

P.S. Remember, stocks priced under $10 have the potential to move quickly. So you might want to get our current recommendations now with a free trial to TheStreet.com Stocks Under $10.