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Why 7th Level Could Come Up Short

If you're short a stock like

7th Level


, the pain has got to be intense.

There you were, watching the stock's long coast into penny-stock land, thinking to yourself, "Yes, Virginia, some stocks


go to zero," when a deal gets announced, second-tier Internet stocks jump, and 7th Level hops 428.5%.

But a hedge-fund manager who claims he is


major short-seller in 7th Level says that he's sticking it out. He argues (no surprise) that there are enough red flags around the company to suggest that, if the speculative froth surrounding

yesterday's spike in Internet stocks blows off, it could be among the first to tumble.

"This is the most egregious example of a speculative stock market that I have ever seen," says the manager, who asked not to be named. "This stock could very easily go back to 2 in the next few weeks."

7th Level shot up Tuesday, ostensibly, because it signed a deal with



to supply its character animation technology to WavePhore's WaveTop Internet broadcast system. It was good news for 7th Level, which has undergone a lot of pain during its transition from a CD-ROM to an Internet company.

But was the news



The deal (terms of which were undisclosed) is probably a revenue sharing agreement, according to

First Albany

associate analyst Ajay Varma, a bull on WavePhore. "We believe, if it's like other revenue sharing agreements, it's going to be based on how often users access the animated content," says Varma, who rates WavePhore a strong buy. He expects WaveTop's revenue will come in at about $2 million in 1998 and $9.6 million in 1999. 7th level will get a fraction of that revenue. And, according to filings, the company needs cash.

In 7th Level's 10-K, filed April 15, the company's accountant,

KPMG Peat Marwick

, wrote: "The company does not have sufficient resources to meet its anticipated operating requirements during 1998, which conditions raise substantial doubt about the company's ability to continue as a going concern." Indeed, 7th Level has been burning cash -- it has lost $61.5 million over the last three years. At the end of December, the company had $2.5 million in cash. In its 10-K, the company said that it "believes actions taken in the second half of 1997 and early 1998 will reduce expenses by over $20 million on an annual basis, to less than one third the rate experienced in the first half of 1997," when its operating expenses were $15.3 million, or about $2.6 million per month. So if everything's going according to plan, the company's expenses are less than $850,000.

The company looked like it was "about out of cash," according to the short seller, until it announced that it has subscriptions for a $10 million private placement of preferred stock today. And that raises a slew of other issues.

Under the terms of the deal, which includes a $4.5 million bridge loan, the company "may be obliged to issue up to 8.275 million shares of common stock on conversion of preferred stock and exercise of any $0.01 warrants." In essence, the company sold 8.275 million shares for $10 million. That comes to a little more than $1.20 a share -- a pretty good deal when you look at 7th Level's close today. The company was down 1 9/16 to 7 11/16. At present, there are only 13.7 million shares of 7th Level outstanding. That's quite a lot of potential share dilution.

In the same press release, the company announced that it is abandoning its merger plans with privately held

Pulse Entertainment

. "Under the originally proposed terms, 7th level would have issued approximately 21 million common shares to Pulse shareholders," the company says in the press release, noting that "our shareholders will experience substantially less dilution than they would have had the merger and related financing been completed." But the company that would have been formed by that merger would have been 60% controlled by Pulse -- in essence Pulse was


7th Level in a reverse merger. Comparing the 21 million shares that Pulse shareholders would have gotten to the private placement is comparing apples to oranges.

So will the hedge-fund manager, who first went short 7th Level back when it was a CD-ROM company, make back his money? For now, he's sitting tight, holding on to 215,000 shares short (as of March 24, total short interest in 7th Level stood at 331,189 shares), but he worries that the stock could blow higher before it comes back down. That could happen, given that 7th Level is seeing an Iomegan amount of speculative chatter on Internet chat boards. ("I may be wrong, From what I am hearing MSFT may take an interest in SEVL," runs a typical

Silicon Investor


"If this goes to 15, I've gotta cover -- I can't blow my quarter on one short," he says. "How could anybody own this? Who the

heck buys

stuff like this?"

Staff reporter

Kevin Petrie contributed to this story.