Steelcloud's Silver Lining
By Brendan Barrett ,
Friday, March 15, 2002 ; 3:55 PM
A lot of companies couldn't survive the failure of a major acquisition, a complete change in business model, and a bad financing deal more commonly known as a "death spiral" or "toxic" convertible.

It certainly knocked the wind out of SteelCloud, a small, publicly traded customized server provider in Dulles. But the company, formerly known as Dunn Computer, has been staging a turnaround in the midst of an unforgiving economy for tech companies.

SteelCloud has been profitable for eight consecutive quarters, and in the last five months its stock jumped 300 percent to $3.00 a share. Not bad, considering the stock languished under $1 a share for six consecutive months in 2001 - long enough that the company had to plead its case last summer before the Nasdaq Listing Qualifications Panel to remain listed on the exchange.

SteelCloud, which remains under the radar screen of Wall Street analysts and institutional investors, provides a good example of a company that is starting to realize the benefits of tough choices and major changes.

"The thing we did was totally cut expenses to a minimum to get them under control, and we changed our business model," says Edward M. Spear, SteelCloud's president and chief operating officer. "We fought very hard to clean up those problems and we're proud of that, but I don't want to dwell on it."

What happened? In 1997, Dunn Computer went public at $5 a share, raising $5 million. Ten months later, in early 1998, Dunn acquired International Data Products, a federal information technology contractor in Gaithersburg, for $23 million.

But 18 months after the deal went through, Dunn wrote down $21 million of the acquisition value in a restructuring charge after the U.S. Air Force cancelled a major computer contract it had awarded to IDP.

"We were in business since 1987, and prior to 1999 we were always profitable," says Spear. "Then we had one bad year based on an acquisition that went bad."

The company reported a net loss of $33.6 million for fiscal year 1999 and its revenue dropped nearly 50 percent from the prior year to $34.4 million. It also began downsizing from about 250 employees after the acquisition to just over 90 today

The failure of the acquisition came as the company was shifting its business model. Until 1997, Dunn had been selling customized desktop computers to the federal government. When the government changed the way it bought computer systems to the benefit of larger contractors, Dunn refocused its business and ultimately changed its name to SteelCloud in 2000.

SteelCloud now concentrates on the commercial marketplace, customizing single purpose servers - such as virus scan servers or virtual private network servers-for software and technology companies so that their software products run optimally.

But last year, one remnant of the acquisition was still hurting the company - a financing deal initiated in March 2000. At that time, the company sold $3 million of convertible preferred stock in a private placement transaction.

Such investments can be complicated, but in general terms when the company's stock price declines the investor can convert its preferred shares to common stock at discounted price. The investor then can sell the shares at a profit, driving the price down further and often triggering a "death spiral."

SteelCloud's financing deal killed its stock, which dropped from $4.25 a share shortly before the deal was announced to $2 a share three weeks after the announcement and then to less than $1 a share for much of 2001.

There was only one good way out of the deal - redeeming, or buying back the preferred shares, which SteelCloud did last July for $2.5 million.

"Rarely are companies in a position to have enough cash to buy the security back from the investor," says Robert Kyle, executive vice president of Directplacement, a company that tracks such investments. But SteelCloud was able to complete the buyback because it had returned to profitability.

SteelCloud's stock has risen steadily since the buyout, and the company expects to grow revenue at a minimum of 25 percent this year, with profits increasing by even a higher percentage. In late January, it announced $10.5 million in contracts with a major federal integrator. But company executives note that the foundation for today's success was laid some time ago.

"It's important to note that the turnaround didn't happen last summer," says Brian Hajost, SteelCloud's executive vice president of sales, marketing and investor relations. "The turnaround happened two years ago when CEO Tom Dunne made the decisive decisions to fix the problem quickly."

The company still faces challenges - three customers accounted for 51 percent of last year's revenue, and its stock does not have a high enough price or volume to attract institutional investors. Bill Loomis, an equity analyst at Legg Mason, says it is "pretty difficult" for such microcap stocks to emerge from the under $5 a share range.

Nevertheless, SteelCloud is starting to get noticed and is optimistic about its future.

"Stock analysts use filters to look for companies moving in the right direction," says Hajost. "All of a sudden we've started appearing on people's screens."

2002 The Washington Post Company