Zitel's Y2K Promise

Steven M. Kaplan remembers the moment vividly. Just back from a week's vacation in Aruba, the Long Island accountant was staring at the stock price of Zitel (ZITL), a company whose stock price had zoomed from 5 to over 70 on investors' belief that the company would make big money helping companies fix the Year 2000 computer bug.

Kaplan, who had bought the stock more than a year earlier at the split-adjusted price of $6.50, was on the Charles Schwab Web site, poised to sell his shares for $70 or better. But just as he was about to click his mouse and execute the trade, he looked over at his desk calendar: Dec. 30, 1996. Better wait until Jan. 2, he thought, to delay paying taxes on the capital gains.

Bad move. Later that day, Zitel shares plunged after it was reported that financier George Soros, who had been rumored to be buying up stock in Zitel, wasn't. Zitel's shares plummeted to $41 by the end of the day; now they're trading below $3.

Kaplan laughs off the episode. "If I keep thinking about what I didn't do, I'll drive myself nuts," he says. "My feeling is that I'll ultimately make money on my investment," he adds.

Maybe so. But there are a lot fewer people who believe there's money to be made from Zitel than there were in late 1996.

The story of Zitel is a story of getting the big picture right but the small picture wrong. The analysts and people who saw possibilities in Zitel more than two years ago believed that the Y2K problem would be a huge, expensive mess. And they were right. They also thought Zitel could make plenty of money from a solution. That's where they went wrong.

Zitel's story probably starts in the fall of 1995, when Gartner Group analyst Kevin Schick put the spotlight on the Y2K market by predicting that companies would spend from $300 to $600 billion fixing the Y2K bug -- quite a leap from an $80 billion estimate he was circulating earlier that year.

In April 1996, Zitel, a Fremont, Calif. company then best known for its computer storage system business, put out a press release confirming that MatriDigm, a company in which it held a 37.5% stake at the time, was developing a "state-of-the-art" solution for fixing the millennium bug, although it hadn't announced any products or services yet.

As described by MatriDigm, the process sounded pretty good. In an October 1996 press release, the company said, "This smooth, efficient and cost-effective system ensures that returned code will function exactly the same as before, while now being four-digit date [i.e., Year 2000] compliant."

Analysts and chat-board enthusiasts beat the drum for Zitel, with postings hitting a frenzied pace on Motley Fool and Silicon Investor by the end of the year. The institutional research firm Emerald Research, a subsidiary of Emerald Asset Management, rated Zitel a "speculative buy" as a Y2K play, pointing out Zitel's numerous risks but also its earnings potential. That report, fueled by mass media's first acknowledgement of the issue, set Zitel shares on fire.

Unfortunately, nothing quite worked out as some analysts had hoped. After the big run-up on Y2K expectations at the end of 1996, Zitel actually did worse in its 1997 fiscal year; royalties from a storage product codeveloped with IBM (IBM) declined, but Y2K sales couldn't fill the gap. Revenues fell from $23.1 million in fiscal 1996 to $18 million in fiscal 1997; 1996 net income of $4 million, or 26 cents per share, became a net loss of $17.5 million, or $1.15 per share.

What's the explanation? "All of us were expecting the market to emerge based upon the estimates of Gartner and IDC and the others," says Zitel president Jack King. To fix their Year 2000 bugs, potential customers didn't budget substantial amounts, he says. "They made the decision to basically do it quietly, in house, using in-house resources," he says.

Stan Corker, director of technology research for Emerald Research, offers additional reasons, such as mistakes made by MatriDigm's management. "We believe the technology is still a good technology, but [MatriDigm] has definitely not executed as well as it could have," he says.

Still another assessment is offered by John Howell, a software consultant from Huntsville, Ala., who says he made more money shorting Zitel stock than he makes in a year at his day job. He says he was skeptical of claims made by the company and its chat-board boosters. "The thing that smelled the most was the idea of the automated fix," he says. "Assuming you generate the source code automatically, you've still got to test it. That's a manual process. There's no way around that."

No matter how the Y2K fixing business has worked out, Zitel is putting the best face on things. The company is putting out press releases announcing various Y2K contracts. And King has high hopes for a new product to sell, one which allows companies to verify their Y2K fixes. "I think there's money to be made," he says. "I think the economics of audit tools are different from remediation," he says. In October, Zitel announced it was merging with MatriDigm in a deal that would make the company well positioned in the "promising" Y2K marketplace. But despite the attention that Zitel still gets on the Yahoo! and Raging Bull message boards, its stock has hardly budged.

Zitel's SEC filing outlining the merger is hardly encouraging. It's filled with pages of warnings about risks -- including the threat of business disruption from the Y2K bug, ironically enough. MatriDigm won't improve Zitel's bottom line in the near future. Although MatriDigm's revenues grew to $3.8 million for the first nine months of its latest fiscal year, up from $42,000 last year, losses stayed in the same neighborhood -- from $10.1 million, or 54 cents a share, to $10.8 million, or 53 cents a share. "MatriDigm's market developed, and continues to develop, at a slower rate than expected," the SEC filing notes about the first 9 months of fiscal '98.

Assessing what he has learned from the Zitel experience, Corker seems sadder and wiser. He talks about the risks of relying on skimpy market information and about the emotions that rule individual investors. "It probably should be kind of a case study for those people who are investing in Internet stocks today," he says.

With the Internet industry, as with the Y2K industry, "you know that it's going to be successful," Corker says. "You know that it's going to generate billions of dollars of revenue. But when you're in the front end of that kind of situation, you can't really accurately identify who are going to be the winners and who are going to be the losers."

For John Howell, shorting Y2K stocks was a harbinger of profits to come. "I'm about ready to short these goddamn high-flying Internet stocks, too," he said earlier this month. "They're such a joke."

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