Apparently, a few of you did not shop enough last month while awaiting the war's end. Retailers reported their April sales in the middle of last week, and large chains such as Wal-Mart Stores ( WMT), Target ( TGT) and Whole Foods Market ( WFMI) not only said they missed their targets, but also forecast light earnings for the quarter.

Investors reacted explosively, and in some cases counterintuitively:

  • Shares of high-end retailers for which expectations were top-shelf, such as Whole Foods, were sent packing. The natural-foods pioneer, sporting a price-to-sales ratio about seven times higher than its industry's average, lost 12% of its market value in a single day after announcing results.

  • Shares of mundane retailers for which expectations are bottom-shelf, such as Trans World Entertainment ( TWMC), rocked. The music and video chain, with a price-to-sales multiple one-fifth its industry's average, has risen 60% in the past month.

  • Shares of online e-commerce companies for which expectations are beyond belief, such as Digital River ( DRIV), arched lazily higher. The Web-services provider, with a price-to-sales multiple five times higher than that of Whole Foods and twice that of its own industry, has risen 35% in the past month.

    The longer-term differential among these three companies paints a compelling picture of the nexus of glamour, expectations and performance. Whole Foods has ridden a big demographic wave, as wealthy baby boomers concerned about their advancing age are willing to pay up for high-margin natural foods. Shares have nearly tripled over the past three years. Trans World faces a declining market for music and video as online piracy has diminished demand. Its shares are down 63% in the past three years. And Digital River, which specializes in helping software makers deliver their goods electronically, still hasn't proven its utility. Revenue is up, but earnings are mixed. Shares are down 8% in the past three years.

    So which of these stocks will ring investors' cash registers over the next two years -- the sure thing, the beat-up thing or the next new thing?

    Shunning Shiny Stocks

    If there's anything investors should have learned from the bear market, it's to be skeptical but cautiously bold. So while I admire the business plans of both Whole Foods and Digital River, I lean toward the stock of Trans World.

    After all, not much has to go right at Trans World for the stock to double in the next two to three years. It is still very cheap vs. its own history and its peers, with a price-to-sales multiple of 0.11 vs. an industry average of 0.5, and a price-to-book multiple of 0.35. In better times it has sold for a price-to-sales multiple of 0.25 to 0.95, so there is plenty of room for a multiple increase.

    Debt is not excessive. And at the end of last month, the company said it expects earnings to come in at 15 cents to 20 cents per share in fiscal 2003, ending January 2004, on sales about even with 2002 levels. To win in this stock, you don't need growth, just the sort of stability that would lead to modest analyst upgrades to "market weight," a moderately higher multiple and a move into more small-cap mutual funds as an economic-recovery story. Short interest is very heavy, so there is a lot of fuel for a squeeze. Meanwhile, Director Robert J. Higgins and CFO John Sullivan were loading up on the stock in the mid-$2 range from October through April -- including many purchases at recent lows in mid-March. A move to $7 to $8 by 2005 seems reasonable.

    Whole Foods isn't doing anything wrong; it will probably move up slowly and steadily, weighed down by expectations for future success as great as its past. Digital River, on the other hand, could see turbulence. The reasons will take a little longer to explain.

    Digital River's Muddy Earnings Waters

    This Minnesota company is best known for an e-commerce platform that helps companies, such as antivirus software maker Symantec ( SYMC), deliver their products digitally through the Internet, rather than via a box in a store. Digital River was an odd bird back in the day when Internet stocks were hot: It rose as high as $61 in January 1999, but crested that year, even as fellow Web stocks went berserk. It ended 1999 way off the pace at around $35. It drifted steadily downward from there, but enjoyed a tremendous resurgence of interest after the September 2001 terror attacks, moving from $4 to $21. Another drift down to Earth ensued, until, in April 2002, it had fallen back to around $4.

    Fast forward from there as it mounted one of its patented screaming moves higher until peaking around $18 on Tuesday amid renewed enthusiasm about e-commerce. On April 23, executives reported a first-quarter net profit of 13 cents a share and revenue of $24.6 million, compared to a loss of 13 cents a share on revenue of $18.1 million in the same period the prior year.

    What's not to like? Digital River ended 2002 with its first two seemingly profitable quarters since the company's inception -- and management expressed optimism about their prospects amid sustained weakness in the technology sector. In an interview Tuesday, CEO Joel A. Ronning said the firm has a "wonderful" business model. "We're at the front end of software delivery via the Internet and a leader in e-commerce outsourcing -- areas that are coming together consistently now and over the next three to five years," he said.

    Yet, a detailed review of the company's Securities and Exchange Commission filings by my colleagues at Camelback Research Alliance has unearthed a series of factors that cast concerns upon the quality of those earnings:

  • A high level of excluded expenses may have led to a systematic overstatement of pro forma earnings and could foreshadow future share-price underperformance.

  • Acquisition accounting can cause an overstatement of the company's revenue growth rate. Once acquisitions are controlled for, the company's growth rate drops from 34.5% to only 7.9%.

  • Several legal issues could adversely affect future earnings and cash flows.

  • Previous-year audits were performed by Arthur Andersen and cannot be relied upon. However, unlike many of Andersen's former clients, Digital River did not engage its new auditor (Ernst & Young) to re-audit previous-year statements.

    Let's take a look at each of these issues briefly, as highlighted by the analysts at Camelback, who also provide the StockScouter rating system to MSN.

    Digital River's earnings reports suggest the company enjoyed four profitable quarters in 2002 on a pro forma basis. But if you look at the company's figures reported under generally accepted accounting principles, or GAAP, you'll note that the strong results stemmed from a relatively high number of excluded expenses. In addition to a $2.5 million litigation charge taken in the first quarter, for instance, the pro forma figures ignore amortization of intangible assets and acquisition-related costs. "GAAP is GAAP, and pro forma is pro forma. We're not deceiving anybody, we've always had them both out there. We're a bunch of good guys doing a decent job," said Ronning, the CEO.

    To get a fair view of a company's performance, under GAAP rules an accountant must line up the costs of items such as customer lists and trade names with the revenue that they generate. When those costs are removed in a pro forma statement, investors are left with a muddled understanding of what's going on. When a company grows by acquisition, the strategy of excluding acquisition costs from earnings as a "nonrecurring" item in the pro forma statement is less than forthright. Overall, exclusions ranged from 26% to 750% of GAAP earnings over the trailing four quarters, according to Camelback calculations, underscoring the degree to which pro forma earnings grossly exaggerate Digital River's newfound profitability. "That's absolutely true," said Ronning. "But that's why we provide pro forma and GAAP results."

    Additionally, although Digital River claims 35% revenue growth in 2002, the company's financial statement shows that much of that figure resulted from an accounting treatment called "purchase-method consolidation." Because accounting rules mandate that two merged companies consolidate their books as of the acquisition date, Digital River's reported revenue growth appears more impressive than it really is. It's as if a baseball team added a new star player in midseason, then reported a win-loss record that presumed the player was with them all year. When revenue is adjusted to reflect the "organic" results that would have been reported had consolidation occurred at the beginning of the period, according to Camelback's analysis, Digital River's revenue growth is revealed to be a modest 8%. "I don't think that's relevant at all," said Ronning.

    More Trouble Downstream?

    Normally when a company cuts expenses, it's a good thing. But sometimes it's cause for concern. Digital River's advertising expense has plunged in the past two years: down 7.5% in 2001, and then down 80.2% last year to amount to just 0.5% of revenue. While such parsimony makes sense in a difficult economy, Camelback points out that the earnings boost generated by the advertising cut could come at the expense of future revenue. It's the equivalent of a farmer cutting down on fertilizer to save money: It might help cash flow now, but those plants ultimately need nourishment.

    Digital River also faces several legal issues that could drain company coffers. Yet the company has not established any balance-sheet reserves in line with the recent litigation-related charge. In one dispute, Digital River executives and the underwriters of its 1998 initial public offering were named as defendants in several 2001 shareholder lawsuits. These suits, which were consolidated with similar cases involving other IPOs, complain that Digital River violated securities law by failing to disclose that its stock underwriters received kickbacks from individual investors.

    And there's one more thing: Digital River replaced troubled auditor Arthur Andersen with Ernst & Young during 2002. Unlike many of Andersen's former clients, however, Digital River did not ask its new accountants to take a second look at its 2000 and 2001 financial results. Given the demonstrated shortcomings of its former auditor's methodology, Camelback warns, Digital River's decision to go without a comprehensive re-audit of prior-year statements appears unwise. "We didn't think it was necessary, and neither did E&Y," said Ronning. "How many companies have spent the money for a complete re-audit -- do you know how expensive that is?"

    The bottom line is that Digital River faces a large market but also numerous serious challenges that may not be fully discounted in the stock price. Yet shares have gone parabolic in the past month and a half, rising from $11 to nearly $19. If its purported earnings growth turns out to be sustainable, great; otherwise, a return at least to the $11-$12 area is a real possibility. Ronning himself proved a shrewd buyer of his own stock, purchasing almost $1 million worth at this time last year when it was at $4.94. There have been no insider purchases since, only numerous sales at around $14 in November.

    The market may elect to forget about valuation once again if it decides to make a new run at Nasdaq 2000. But if balance sheet and income statement questions return to view, stocks with the most to lose are the ones of whom the most is erroneously expected. Then companies such as Trans World have a fighting chance, and companies such as Digital River could be in for a real dogfight.
    Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at At the time of publication, his fund held no positions in any of the named securities, but positions can change at any time.