Don’t Bet the Farm on Serial Persistence
The serial persistence of Venture Capital returns has become something of an article of faith within the limited partner community. Serial persistence basically means that the best indicator of future VC performance is past VC performance (See Paul Kedrosky’s thoughtful posts on this topic here, here, and here.) These days LPs talk about getting "allocations" in top quartile funds the way high school seniors talk about getting into their "first choice" college: they seem to possess an almost blind faith that just getting accepted will guarantee them many years of above average returns thanks to the wonders of serial persistence.
If only it were true. The reality is that making money investing in venture funds is a lot harder than simply putting as much money as possible behind the best performing funds that will take your money. That’s because while top quartile performance is indeed a significant determinant of future performance, it’s not a sole or even a sufficient determinant.
Arguably the most definitive study on this issue comes from the University of Chicago and was authored by Steve Kaplan and Antoinette Schoar. The study took a database of every venture and private equity fund in existence between 1980 and 2001 and analyzed it to see if, among other things, returns were serially persistent within GPs across funds. Sure enough, the study found strong statistical evidence that past performance by a GP was a significant factor in explaining the variability of future performance, i.e., for individual GPs, returns were serially persistent across time.
For many in the VC and LP community, this study simply confirmed conventional wisdom in that the only “can’t lose” way to make above average money in venture was to “bet the farm” on top quartile firms.
Unfortunately, the actual numbers suggest that betting the farm solely on past performance may be much riskier strategy than one might imagine. Elsewhere in the study, the authors’ analyze the probability that a GP with a top tercile fund will generate another top tercile fund. It turns out that this probability is. at best, a coin-flip. In other words, there’s only a 50% chance of a GP delivering back-to-back top tercile performances. That’s hardly a "lock" and not the kind of numbers that should inspire someone to bet the farm. In addition, even though the study did not divide performance into quartiles (as is often the custom in VC fundraising), I had a brief exchange with Steve Kaplan in which he confirmed that the same pattern not only holds for quartiles, but that the probability of a GP having back to back top quartile funds is significantly lower than 50%.
I would be willing to bet a large sum of money (perhaps even “the farm”) that if you surveyed 100 LPs today and asked them “what is the probability of a top quartile fund repeating that performance” that you would get an average result well above 50%, and probably closer to 75%, thanks to the prevailing conventional wisdom. So what’s most interesting to me about the U of C study is how far off-base this supposed wisdom really is. After all, according to the study, a new fund of a top tercile GP has just as much chance of becoming a 2nd or 3rd tercile fund as it does a top tercile fund.
Of course, I should point out again that the rest of study, as well as these probabilities, makes it clear that past performance is definitely something that should be considered carefully when making new venture investments and something that it is more significant than many other factors, however it’s also clear that blind allegiance to past returns as a predictor of future performance is not much better a recipe for success than simply flipping a coin. As Kaplan himself pointed out to me in our exchange, there are a wide range other factors that people need to consider when investing including partner turnover, motivation levels, style creep, etc. in addition to past performance.
Personally, I think that as the number of funds and average assets under management increases, achieving back-to-back top quartile performance will become harder and harder thanks to the inevitable dispersion of “home runs” across a wider base. This will make it increasingly difficult for LPs to invest via their rear view mirror and will require much more forward looking due diligence on the prospective strategies of individual GPs. Of course, this perspective doesn't play with the self-serving Sandhill party line that the best VCs will always be the best VCs, but I find such sentiments delusional because they in effect assume infinite economies of scope for the best VCs as the industry scales and those simply don't exist.
As for the serial persistence of GP returns, I buy it on an academic level, but given the probabilities involved, at a practical level I have a hard time seeing how anyone can reliably translate that academic insight into actionable decisions with absolute confidence. In this light any LP that is making "top quartile performance" the sole reason for making an investment or the litmus test for even considering one is likely making a big mistake. My bet is that in 20 years, outside of few exceptional cases, the VC industry will look a lot more like the mutual fund industry where serial returns are not believed to persist in any significant way.
Datapower: VC Lessons
IBM announced today that it was acquiring Datapower. I’ve written another post on why I think this announcement is significant from an industry perspective, but given that I was an investor in Datapower, I thought I would also write a post about some of the venture capital aspects of the deal.
I invested in Datapower in early 2002 when the company had 6 employees and was based in a mouse infested former auto-body shop located between two housing projects. Datapower was founded by Eugene Kuznetsov, a brilliant MIT engineer, who saw the promise and the challenges of XML messaging early on.
Like all venture deals, I learned a lot from my Datapower experience, but here are a few of the most important things I learned:
- Local presence matters. I live and work on the west coast. Datapower is in Boston. When I first wanted to invest in Datapower my partners’ first reaction was “it’s too far away, you need a local partner”. They were right. I spent the next few months trying to find just the right partner. Luckily Jeff Fagnan, who was then at Seed Capital (a fund I knew well) had already been looking at the space and quickly decided that he would like to join us in the investment. Jeff proved to be an invaluable co-investor and ultimately got stuck with much of the day to day investment management chores that I could not effectively do. It was an important lesson for me on the critical importance of having high quality local co-investors if you do a deal “out of market”. Incidentally, Jeff left Seed early this year to become a partner at Altas and his first investment at Altas just happened to be in Datapower. I suspect everyone at Atlas is happy with the IRR on that investment!
- Sometimes VCs should keep their mouths shut. Just after Datapower had launched its first product, a performance oriented appliance, Eugene lobbied for the company to accelerate the launch a second security oriented product that had been planned for a quarter or two in the future. At the time, I remember cautioning Eugene on the potential distractions and costs of having two immature products in the market at the same time. Eugene lobbied hard to take the risk and thankfully he won the day. I say thankfully because not only did the company land a $300K order that quarter for the security product, but it was able to establish significant mindshare in the security space well ahead of its competitors. To this day the security space continues to have the most robust market demand and competitors that failed to quickly launch a security product suffered in the market. The lesson for me in this was that VCs have to be careful not to micro-manage product development in a rapidly emerging market because demand can move very quickly and in unexpected ways.
- Shotgun Weddings Don’t Work. Early on in the company’s life we were trying to recruit another local investor into the deal. That investor had an entrepreneur-in-residence (EIR) that helped them with due diligence and really liked the deal. The new investor made recruiting an interim Chairman/CEO a condition of their investment and there was an implicit understanding that they would feel most comfortable with their own EIR taking that role. The existing team was not 100% comfortable with the EIR but felt pressured to take him on in order to secure the funding. As it turned out, the EIR was the wrong person for the job and tension started to develop between the existing team and the EIR to the point where it became a major distraction for the company. Ultimately, the board ended up hiring a new CEO who turned out to be a much better fit, but we almost blew it by not taking action earlier. The lesson for me as an investor is that you should never insist on making a company hire a specific person a condition of investing as that dramatically raises the potential for conflict. You are much better off investing in advance and helping the company recruit someone great that everyone is 100% confident in.
- VCs can indeed be very unethical. Prior to raising his first significant round of venture financing, Eugene had raised a seed round from a few individuals and a couple of investment funds, one of whom was a reasonably well known VC fund. The partner at this fund had a strategy of sprinkling small seed investments around the Boston-area and then trying to lead the first institutional rounds of any company that looked particularly promising. In Datapower’s case, this partner invested a few hundred thousand dollars. He also introduced Eugene to a technology executive affiliated with the fund that was currently in-between jobs and encouraged Eugene to involve the executive closely in the formulation of Datapower’s technology and market strategy. Everything was ok until Eugene decided to raise his Series A financing. At that point the VC fund submitted what was clearly a low-ball term sheet and pushed very hard to close it. When Eugene objected to the terms and announced that he would try to generate some alternative offers to see if this was in fact “market” he found that he couldn’t get any traction with other Boston based VCs most of whom would either not meet with Eugene at all or who told him that they would not do the deal without also including the original VC (at the terms they had proposed). Now I don’t know if the original VC had an active campaign to try and discourage other investors from doing the deal, but they obviously knew that new investors would not want to do the deal without them (if the original investors don’t invest that is typically a big warning flag that something is wrong) and used that leverage to try and get a better deal. While to this day I use this situation as a classic example of why entrepreneurs shouldn’t have a VC in their seed round, if that was all there was too it there wouldn’t be much to write about. However after Eugene rejected their term sheet and instead ultimately accepted mine, the VC in question went ahead and not only invested in a competitor, but installed the same executive that they had installed at Datapower at their new investment. Within months, this competitor began spouting very similar marketing messages and appeared to be executing against a carbon copy of Datapower’s product and market roadmap. This brazenly unethical behavior by the VC fund was absolutely stunning and so egregious that it almost was a caricature of what you expect an “evil VC” to do. To add insult to injury, when the Series A investors in Datapower approached this fund, politely pointed out the rather obvious conflicts, and requested that the fund sell its shares back to the company or to other investors, the fund refused. Luckily Eugene got the last laugh though. The competitor the original VC fund invested in was recently sold in a transaction that reportedly didn’t even return capital handing many of its investors a substantial loss on their investment. In contrast, Eugene is now a very deservedly wealthy man and all of his investors made a handsome return on their investments. I guess good guys do sometimes win.
One last piece of trivia: I closed two investments on January 14, 2002. (It’s highly unusual for a VC to close two investments the same day.) The first was in a company called Cyanea and the second was in Datapower. Both companies ended up being bought by IBM; Cyanea last summer and Datapower today. While Cyanea generated a higher IRR, the difference in cash-on-cash return multiples between the two deals was less than 10%. I have got to close two deals on the same day more often!
IBM Acquires Datapower, Software Will Never Be The Same
IBM announced today that it was acquiring Datapower, the pioneer of message aware networking. As some may know, I invested in Datapower and given that I’ve written another post on some of the venture capital aspects of the deal, but I thought I would also write this post about the higher level significance of deal from an industry perspective as I think it is pretty interesting for anyone involved in software.
From an industry perspective, IBM’s announcement is significant for a few reasons:
- It represents very a powerful endorsement of the long term promise of message aware networking.
Message aware networking involves shifting the processing of software messages away from applications (and their associated middleware) into specialized hardware devices. These devices dramatically improve the security, performance, and manageability of software messages. As I have written before, message aware networking is one of the top trends in the software industry, but up until recently most of the major technology companies had yet to make a commitment to the space. However in just the past few months a number of tech heavyweights have weighed in on the space. First, Cisco announced its AON line of message aware network equipment and then Intel surprisingly announced that it was getting back into the space when it acquired one of Datapower’s smaller competitors, Sarvega. IBM’s move now marks the first major enterprise software vendor (and arguably the most influential one) to embrace the trend. So in the space of just a few months, message aware networking has gone from the province of just of few enterprising start-ups to a major battle-zone between some of the tech industry’s biggest titans. Much of this has to do with the growing realization that as software is broken into smaller and smaller pieces that are distributed further and further apart, that the messages between these software pieces are becoming an incredibly important. In this environment “the message is becoming the software” to such an extent that the processing and handling of the messages is becoming as important if not more important than the application itself. IBM’s entry into the space, with its vast stable of enterprise customers and huge enterprise “stack” will likely accelerate the adoption of message aware networking (and the Service Oriented Architectures that sit on top of it) and will put pressure on other software vendors to follow suit.
- It underscores the inevitable collision between enterprise software and enterprise networking vendors.
Message aware networking sits in a supposed “no man’s land” in between enterprise software and networking. It looks a lot like networking because it requires high speed dedicated devices to process large numbers of standards-based messages, but it also looks a lot like software because it requires intelligent middleware to make content and context sensitive decisions. Because message aware networking did not naturally fit into the networking space or the enterprise software space, the big guns in each space weren’t really sure what to do. However with a potentially huge market at stake, neither side was prepared to concede the market to the other. Ultimately, Cisco broke an uneasy truce and moved into the market with its AON products. In this light IBM’s purchase of Datapower can be seen as a direct response to Cisco’s moves. These moves and countermoves come despite the fact that Cisco and IBM are supposed to be the best of friends. However, as I outlined in an earlier post, Cisco and IBM are destined to find themselves competing head-on much more frequently thanks in large part to the inexorable melding of the traditional networking world with the traditional middleware world. Who knows, they might have even competed over Datapower. This “battle of the stack” will likely be one of the most important enterprise computing stories of the next decade.
- It marks what is likely the beginning of a very aggressive push by IBM to develop a fully featured SOA “stack”.
As a wise man once said “He who says A, must say B”. In buying Datapower, IBM is making it clear that they intend to build to a robust stack of message oriented products. As relatively “dumb” yet critically important message processors, Datapower’s products will likely serve as the foundation for a wide array of message oriented products, which will mostly be grouped under the Service Oriented Architecture (SOA) label. With the foundation in place, IBM will likely add products with other features such as SOA management, BPEL-based business process management. Datapower’s acquisition is critical because it secures IBM’s rear flank from attack by the networking vendors and allows them concentrate their full force on enterprise software related issues.
I admit, it’s a bit of a stretch to say that software will never be the same after IBM’s acquisition of Datapower, but I do think that the acquisition underscores the fact that some of the biggest names in technology now endorse the fundamentals tenants of message oriented networking and that this promises to help spur long term changes in not just the architecture of software programs but in the competitive positioning of the technology industry.
Early Warnings Signs A Software Stock Is In Trouble
Owning software stocks can be a frustrating experience. Just when you think they can do no wrong, they often miss their earnings and fall like a rock only to rise up over the next few quarters and then have that renewed optimism crushed yet again by another earnings miss. It can, and has, driven many a software investor crazy.
In the face of such volatility, knowing when to get out of software stock is critically important. Given this importance, I thought I would provide a list of the Top 10 Early Warning Signs that a software stock is about to crater. This list is largely based on my experience on Wall Street and as a VC and is by no means fool proof, but if you own a software stock (or are considering buying one) that has more than a few check marks on this list, you will want to be extra vigilant as there’s a decent chance your stock is headed for a meltdown.
Top 10 Early Warning Signs A Software Stock Is In Trouble (in no particular order)
- It capitalizes software development expenses.
According to a very silly FASB rule, software companies are required to capitalize development expenses for a specific product once they are reasonably certain that the product will be completed. It just so happens that by capitalizing software development expenses software companies can also improve near term earnings by effectively amortizing current development costs over a longer period of time. Because it’s very subjective just what costs can be attributed to a specific software project, it’s very easy for companies to ratchet up and down the % of development expenses that they capitalize with little or no objections from their accountants. These factors have combined to make software development capitalization the heroin of software companies: you get a strong sense of elation when you use it to get by that first tough earnings period, but pretty soon you are completely hooked and are constantly increasing the capitalization rate to achieve the same effect. Thankfully, most software companies do not capitalize software development expenses for several reasons including A) they realize once they start capitalizing it’s hard to kick the habit and B) they know that institutional investors hate it and that it will damage their stock. That said, a large number of software companies still capitalize software development costs. Thus, the stock of any company that capitalizes development should be approached with extra caution, especially one where the capitalization rate (Capitalized Costs/Total R&D spending) is increasing.
- DSOs are greater than 95 days.
DSOs or Days Sales Outstanding is typically viewed as a measure of how efficiently a company collects its accounts receivable. High DSOs can potentially indicate two types of trouble at a company: 1) The company may be having trouble collecting accounts receivable because customers are either unable or have refused to pay. 2) The finance department may be mismanaged which raises the possibility that the company’s finance-related processes and controls are in bad shape. Some companies have good excuses for high DSOs, such as channel partners who habitually report late due to their own processes, but in general there’s no excuse for high DSOs. Something in the range of 60-80 should be the norm and anything else should raise questions.
- License revenues account for less than ½ of overall revenues and are declining.
Licenses are the lifeblood of a software company. The more licenses, the more long term revenue growth potential in the form of services, maintenance, and additional license sales/upgrades. When license sales start declining as a percent of overall revenue it’s typically a warning sign that the market is becoming saturated and that overall revenue growth rates will be lower in the coming years. Of course, declining license growth is a fact of life for most software companies as they age, so the real key is to make sure that the stock price doesn’t imply higher growth rates than the license revenue trends seem to support.
- It reports more than 30 days after the end of the quarter.
Generally speaking, how fast a company reports it’s earnings is a fairly good indicator of how well managed the company is. Closing the books on the quarter not only takes good financial systems and processes but also good operational systems. If it takes a company 2 months to report its quarter, chances are that’s because their internal systems are royally screwed up and/or they are locked in a battle with their auditors over the more “aggressive” elements of their financials. There are some good reasons that it might take more than a month to close the books (usually related to channel/partner issues), but in general any company taking longer than 30 days should be assumed to have a lot of bubblegum and masking tape holding together their internal systems.
- EBITDA Margins are less than 10%.
Software is a pretty good business. It takes relatively little capital to get going and software products can typically generate gross margins in excess of 90% quite easily. Indeed, the best software companies can produce net margins in excess of 35%. In this light, failing to produce at least a 10% EBITDA margin in a reasonably mature software company is pretty much inexcusable. If a company is unable to generate a 10% margin it means that it is either facing severe price competition or has a wildly bloated cost structure, neither of which is very encouraging.
- It does not provide a cash flow statement when it announces earnings.
Cash flow statements are critical to assessing the underlying quality of an income statement. If a company announces its earnings but doesn’t provide a cash flow statement it is basically leaving out the most important piece of the puzzle. Failing to provide a cash flow statement may also indicate that the finance department doesn’t have their act together which undermines the credibility of any forecasts and estimates they are making. Eventually the company will have to file a cash flow statement with their 10Q, but there a few good excuses for not having it ready when they report earnings.
- It misses ship dates.
Software companies are essentially code factories. If a software company fails to meet an established deadline for shipping a new product it often means something is seriously wrong with the factory. Granted, there are some legitimate reasons for missing ship dates, but almost any miss by more than a few weeks is strong circumstantial evidence that there are serious problems in engineering, product management or both. Missed ship dates are not only important because they provide a measure of how well the factory is running, but they also are critical to driving revenues.
- Its deferred revenues are declining.
Deferred revenues are revenues that the company is generally guaranteed to recognize a few quarters in the future. These revenues have become more important as companies are forced by revenue recognition policies and subscription-based licensing to defer an increasing amount of their revenues. If deferred revenues are increasing faster than GAAP revenues that generally is a sign of strong growth. If deferred revenues are decreasing that can mean that growth will soon slow down. It also means that there are less revenues “in the bank” for the next quarter which can increase the risk of an earnings miss.
- The head of sales and marketing leaves.
If the company fires the head of sales and marketing it generally means that he is going to or has been missing his numbers. If the sales and marketing head resigns on their own, it generally means that they think they are going to miss their numbers or can make more money working somewhere else. Either way, it’s usually bad news for the company over the next couple quarters.
- Competitors miss their forecasts.
While it's possible a competitor missed their earnings forecast as a result of competitive pressures, due to the fast growth and relative immaturity of many software markets, it’s more likely they missed due to general weakness in customer demand. This means that investors should closely follow the forecasts and results of firms that are directly or indirectly competitive with their investments.
Software Stocks Upate: September 2005
The Software Stock Index was down 0.9% in September compared to the NASDAQ's 0.0% flat line. The average stock was actually up 3.0% indicating the small caps had a much better month than big caps. In fact if it wasn't for a 6% loss by Microsoft, the whole sector would have been up 1.9%. As it was, the best performing sectors were Operating Systems (+34%) led by Redhat's surge on positive earnings, Content Management (+16.1%) thanks largely to Convera's continued speculative ascent, and Customer Relationship Managment (+12.2%) thanks largely to Siebel's jump on Oracle's takeover bid and resulting sympathy rallies from CRM and RNOW.
The worst performing sector was Microsoft (-6%), a sector all to itself given that it comprises 1/3 of the software market's $776BN in market cap. Databases (-4%), led by Oracle's decline on disappointing earnings, was the second worst performing sector while PC-Based Financial Services Software declined 2.2% due exclusively to a bit of weakness in Intuit.
From a valuation standpoint, the weigthed average average Price/Sales was 4.6X and the weighted average P/E was 26.5.
On the M&A front, the software industry continued to consolidate with the acquisitions of Nuance and Aspect Communications closing as well as a number of new bids being announced. Since the beginning of 2004 for every new software company that has gone public, 6 companies have either been acquired or have gone out of business.
For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.
I have improved the spreadsheet this month with a more fundamental financial data and ratio's for about 85% of the companies in the index.
Internet Stock Update: September 2005
Internet Stocks were up a strong 3.4% in September vs. the NASDAQ's 0.0% flat line. Tom Online, the Hong-Kong based chinese portal and moble entertainment firm was the month's biggest gainer at 28.8% thanks to general enthusiasm for Chinese-related internet stocks last month in the wake of Mary Meeker's bullish report on the sector. The biggest loser was online Poker site Party Gaming, which was down a whopping 42% (shaving a cool $5BN off of its market cap) after talking down its revenue growth prospects on its first post-IPO earnings call.
From a valuation perspective, the weigthed average P/E of the internet sector was 40.5 at the end of the month and the weighted average Price/Sales was a hefty 7.8X.
There were two Internet related IPOs in September. WedMD was spun-off from its parent as a stand alone company while 888.com, one of the largest online casino/poker players had a disappointing IPO that was dragged down by the turmoil at Party Poker.
For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here
to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.
The spreadsheet has been improved lately with detailed fundamental financial data and ratios for almost all of the stocks.
Virtual Stock Portfolio Update: September 2005
In September my virtual stock portfolio was down 1.6% compared to the
NASDAQ's 0.2% gain. On average my stocks were down 1.4%. My portfolio should have done much worse as the online gambling sector, which I was long to the tune of about 1/3 of the portfolio, got clobbered by a poor earnings announcement from Party Poker, but fortunately my shorts were up 5% which cushioned the blow significantly but not enough.
Overall, my portfolio is up 19.5% YTD vs. a decline of 0.9% for the NASDAQ, so I am still nicely ahead of the market. That said, I have decided to make some fairly major changes this month after a number of months of relative calm in order to better position the portfolio for the Q3 reports and to get some new blood into the portfolio.
Company: SPSS Ticker: SPSS
Sub-sector: Business Intelligence
Investment Thesis: SPSS is a player in the business intelligence space with a particular emphasis on predictive analytics, something that is particularly hot right now. The stock has been battered by a restructuring that the company went through last year as well as an accounting restatement. My thesis is that the new product set is strong and the accounting trouble is overblown.
Performance: Since 4/30/04: +68.8% Sep. vs. Aug.: +11.2%
Comments: SPSS closed the valuation gap and now acutally trades at a premium to the group. They had a good product cycle in Q3 with a major release of their core product so they should have a good Q3, however the stock seems to have already priced this in. With the stock trading at a premium to the BI group its recovery is now complete so I am going to close out this position even though the stock is trading very nicely right now and may still run a bit.
Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, content management company that is attractively priced. I like the content management space as a consolidation play.
Performance: Since 6/30/04: 0.4% Sep. vs. Aug.: +5.6%
Comments: I've held this position for over a year and it has gone exactly no-where. In retrospect, I added this stock to the portfolio about a month too early. Ever though I still like the content management space, I am going to close out the STEL position because the stock just can't seem to get any momentum and I think there are more attactive names in the same space at a better price.
Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Financial Services
Investment Thesis: Every portfolio needs a flier and this sure counts as one. Neteller is Europe/Canada’s answer to PayPal and it has been making a killing by servicing markets, particularly on-line gambling, that PayPal has been pressured into exiting by the US Justice Department. I know, I know, this is not a software stock, but I still follow on-line financial services quite closely and I feel compelled to point out this stock because it is such an attractive buy.
Performance: Since 6/30/04: +409.1% Sep. vs. Aug.: -5.5%
Comments: This stock has had quite a run. I still can't believe that I added it at roughly 8X earnings. While it still only trades at 22X earnings, thanks to last month's carnage in the online gambling sector, 22X earnings is now a healthy premium to the rest of the group. As my grandmother once said, you don't make any money if you don't sell, so with the stock at a premium to the group, it's time to sell.
Company: Sportingbet Plc. Ticker: SBT.L
Sub-sector: Internet Gambling
Investment Thesis: Sportingbet is the largest on-line gambling operator in the world. At 23-25X 2005 EPS this stock is still attractive relative to its growth rate (25-30%) and especially attractive relative to other Internet commerce plays. I don’t like the big options overhang in this stock or the poor margins (due to sports betting business) but this is a chance to own a major player in an important on-line commerce player at an attractive valuation.
Performance: Since 11/30/04: +86.7%, Sep. vs. Aug.: -12.2%
Comments: SportingBet was hurt this month by Party Poker's poor earnings announcement as well as rumors that it was planning a very expensive acquisition of Empire Poker. With Party's implosion, SportingBet is now trading at a significant premium to the group for no apparently good reason. In addition, the price they were apparently considering for Empire indicates that the management team isn't too concerned about dilution. Even though that deal is dead, I can't help but think that SportingBet is due for some significant multiple contraction as it comes back into line with the other online gambling players. As a result I am going to close out my long position and add SportingBet to the short side of a paired trade I will discuss a bit later.
Company: Microstrategy Ticker: MSTR
Sub-sector: Business Intelligence
Investment Thesis: I like the BI space in general and have been keeping my eye on Microstrategy. This has recently been one of the cheaper stocks in the space, yet it also has one of the better product portfolios and market positions. From what I hear, businesses are still spending big bucks on BI and MSTR should be a big beneficiary.
Performance: Since 3/31/05: +29.5%, Sep. vs. Aug.: -7.5%
Comments: I am going to hold on to MSTR for the time being. Thanks to its stock repurchase plans it is probably the cheapest major name in the BI space right now. There are a lot of people betting against the stock (25% of the float is short), but while the Q3 report may be tight, I think MSTR will benefit from the strong market for BI in general. If they upside surprise the stock will see a huge jump as the shorts squeeze.
Company: FireOne Group Ticker: FPA.L
Sub-sector: Financial Services
Investment Thesis: FireOne operates an Internet payment service very similar to Neteller. It is used primarily by on-line gamblers to transfer money around. I I added FireOne to the portfolio because I wanted to maintain overweight exposure to the these kind of Internet payments plays without putting all my eggs in one basket (Neteller). Now that I have closed out Neteller this will be sole exposure to Internet payments. I am holding on to FPA because it trades at a discount to Neteller.
Performance: Since 7/31/05: -0.4%, Sep. vs. Aug.: -17.9%
Comments: This was the portfolio's biggest % decliner in September due primarily to Party Poker's implosion. It was probably hurt more than others due to its poor float. It should be able to bounce back a bit this month as it now trades at a discount to Neteller.
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: Acutate is a business intelligence company with a particular focus on enterprise reporting. I had a long postion in ACTU in 2004 and lost money on it, but I think the stock is back on the upswing now thanks to an improved product line and focus. ACTU trades at a healthy discount to rest of the BI group (kind of like SPSS did at one point) and every penny of upside in its EPS could really move the stock.
Performance: Since 9/30/05: NA Sep. vs. Aug.: NA
Comments: Very makable EPS estimates and a strong overall BI market suggest that this could go to $3/share with ease.
Company: OpenText Ticker: OTEX
Sub-sector: Content Management
Investment Thesis: OpenText is a content management company that went on an acquisition binge in 2003 and 2004. The stock suffered from all the M&A related charges and fallout but managment now claims that they are going to resolutely focus on EPS growth. OTEX trades at a healthy discount to the rest of the content management group and has a broad product portfolio. Integration snafus could trip them up, but the low multiple on the stock should limit any potential damage.
Performance: Since 9/30/05: NA Sep. vs. Aug.: NA
Comments: Watched this have a strong month in September so I hope I am not late to the party.
Company: Cryptologic Ticker: CRYP
Sub-sector: Gaming Software
Investment Thesis: Cryptologic is a provider of gambling software to online casinos and poker rooms. They license their software to numerous companies in return for a cut of the take. About 70% of their revenues are from casino related software sales and about 30% from poker related sales. Since they are a technology provider and not an operator they actually are listed in the US and do not appear to be in danger of violating any online gambling laws.
Performance: Since 9/30/05: NA Sep. vs. Aug.: NA
Comments: Trades at 13X EPS with a 1.2% yield. Much cheaper play on online gambling than SBT and less pure play exposure to poker. One of the only "pure play" online gambling stocks you can trade on a US exchange.
Long: Party Gaming Ticker: PRTY.L
Short: SportingBet Ticker: SBT.L
Sub-sector: Online Gambling
Investment Thesis: Party gaming is the largest online gambling company in the world with an exclusive focus on poker. Party went public this summer at 100p and got up to 140p before getting creamed when it talked down its revenue growth prospects on its 1st earnings call. The stock is now below its IPO issue price and at this level it is not only at 12X earnings, but 12.4X cashflow (of $500M/year) for a cash flow yield of over 8%. The concerns about Party's growth (and online poker's growth in general) are overblown. Empire Poker, which is a "skin" of Party (which means it not only uses the same software as Party, but pools its users with Party) had a very respectable quarter which appears to indicate that Party's problems were very much company specific and likely had something do to with all the distractions surrounding it IPO. In comparison to Party, SportingBet is trading at a substantial premium (21X vs. 12X) even though much of the excitement surrounding SBT has to do with its acquisition of Paradise Poker (the #5 poker room). It will be tough for SBT to sustain the premium to Party given Party's superior margins, cash flow and growth rates. With the paired trade the legal risk facing the sector is minimized because both would likely suffer equally from any legal action. Up until now these kinds of trades didn't make sense because all the names traded pretty much in line with each other, but with Party's somewhat unwarranted implosion this is a perfect opportunity to put on such a trade.
Performance: Since 9/30/05: NA Sep. vs. Aug.: NA
Comments: Pair trades are often all about multiple compression. Given that both names only formally report twice a year it may take awhile for this to play out, but this feels like a pretty conservative way to play this space. The more adventurous may want to just go long on Party given that it will probably start a heafty dividend/buyback program early next year.
Company: Autonomy Ticker: AUTN
Sub-sector: Content Management
Investment Thesis: Autonomy is a UK-based purveyor of advanced enterprise search software, a space I know well from some of my VC investments. The enterprise search space is crowded and getting even more competitive with the entry of folks like Google. Autonomy’s secret sauce, its categorization software, is increasingly being duplicated by it competitors. Autonomy continues to trade at a premium to the market. This premium appears to be largely an artifact of the fact that autonomy is a bit of a cult stock in its home country of the United Kingdom.
Performance: Since 1/26/04: -9.3% Sep. vs. Aug.: 4.4%
Comments: Good lord. At one point I was up almost 50% on this short, now I am down almost 10%. I guess I have gotten a good lesson in not being greedy because the stock went crazy this summer (along with anything else search related). The whole search enterprise search space is incredibly frothy right now (witness the madness with CNVR), but there's no use trying to fight hype. In addition, AUTN is buying revenue to make it look like they are growing and no one seems to care. The movement makes no sense to me and now AUTN is back to trading at loopy levels (7.8X EV/Sales) however rather than wait for vindication, I am going to cover and wait for a better time.
Company: Wave Systems Ticker: WAVX
Investment Thesis: I first encountered Wave when I wrote my initial analyst report on Wall Street in the mid-1990s. Wave has remained in business largely by claiming that it is developing revolutionary security technologies, kind of like a bio-tech company that never gets out of trials. With a grand total of $1.4M in revenues over the last 3.5 years, a $4M/quarter cash burn rate and only $4M or so in the bank, a day of reckoning is fast approaching.
Performance: Since 10/1/04: -2.2% Sep. vs. Aug.: 9.8%
Comments: After a very suspicious run-up in advance of its latest PIPE (done at a whopping 20% disccount in fully registered shares) WAVX has predictably traded back down. The only thing left supporting this company is a group of delusional retail investors (they call themselves "Wavoids") who for some reason believe the promises of a management team that has blown through $275M in capital and had $258K in revenue to show for it last quarter. The company continues to burn through cash at a clip of $1-$1.5M/month without any real restructuring or sign of urgency. A VC would get shot for running a company like this. At some point, someone has got to figure out the emperor isn't wearning clothes.
Company: Manugistics Ticker: MANU
Sub-sector: Supply Chain
Investment Thesis: Manugistics is in a tough spot strategically and financially. Strategically it's facing increased competition from the big ERP players who are successfully bundling more and more supply chain functions into their core offerings. Financially, Manugistics has a crushing debt load and a negative tangible book of $55M. It's going to be very hard to pull this company out of the tailspin. The debt holders may ultimately convert to equity and save the day, but things will have to get a bit worse on the equity front before they are willing to talk turkey.
Performance: Since 2/28/05: +1.5Sep. vs. Aug.: -5.8%
Comments: Reported a very poor Q2 with license revenues continuing to fall off a cliff. However, positive momentum at ITWO (another fallen supply chain angel) has attracted a lot of retail investors looking for a flyer who apparently don't realize that $170M in convertible debt is due in 2007, thus the stock traded down only briefly after its dreadful report. It makes no sense to hold this position in the short term if the crowd is going to ignore terrible fundamentals and bet on the come, so I am trading out this month and will look to get back in once it is clear nothing is going to magically appear to pay off the debt.
Company: Kana Software Ticker: KANA
Investment Thesis: Kana has been in a long decline ever since the bubble burst. Once a CRM darling, it is now generating only about $2M in license sales/quarter and $10M in total revenues. It continues to lose millions a quarter despite having only ~$10M in cash. In addition, the CEO recently left in the wake of getting censored for expense account abuses and the company hasn't filed a 10K or 10Q because they have new auditors that are taking much longer than expected. The new CEO is going to have to undertake a major restructuring to get this place profitable. This company may ultimately experience the same fate as Broadvision in that it goes private at a big discount.
Performance: Since 7/31/05: 0% Sep. vs. Aug.: 0%
Comments: Raised $4M in common stock financing at the end of September with another $1M in committements pending the successful filing of their 10Qs. The investors are putting in the money at market with warrrants that are out of the money, so they must think that things aren't that bad. I am starting to think that this may get sold at market, so I might as well cover my short and move on to greener pastures.
Company: Citadel Security Software Ticker: CDSS
Investment Thesis: Citadel offers a subscription service to help companies spot security vulnerabilities. It's a good idea, but a lot of other companies including a number of private companies offer the same service. Lately Citadel's business has been falling off a cliff. They are buring cash to the tune of $5M/quarter and yet the management team hasn't done any major cost cutting. They have bank loans of $3.5M which are due this month and no way to repay them short of a massively dilutive financing or fire sale. As a VC, I can tell you first hand that it is incredibly difficult to turn around this kind of situation even if you get some product momentum. I haven't seen a single company in this kind of shape pull it out.
Performance: Since 9/30/05: 0% Sep. vs. Aug.: 0%
Comments: Might be a month late on this. It was down 30% last month as people started to realize that the rapidly approaching object wasn't a new wad of cash, but a big brick wall. Their commerical bankers have got to be awfully nervous. I am betting on a very dilutive financing at something like $0.30/share.
Company: Emerge Interactive Ticker: EMRG
Sub-sector: Vertical Applications
Investment Thesis: Do you need software to help trade and manage cattle? Apparently not many other people do either, otherwise EMRG wouldn't have generated only $335K in revenues last quarter. With cash finally running out after $205M in losses this company should be headed for the slaughterhouse shortly.
Performance: Since 9/30/05: 0% Sep. vs. Aug.: 0%
Comments: I like my steaks almost as well done as this stock.
Company: Entrust Ticker: ENTU
Investment Thesis: Entrust started out providing Certificate Authority software for use in public key encryption and now has a broader line of identify management products. I know them from my days covering the security sector on Wall Street. They seem to disappoint at least once a year and given that the stock has now fully recovered from their last dissapointment they should be due again. It doesn't help that most of the major software players, including IBM Oracle and CA, have made their own identity management acquisitions in the past 18 months either.
Performance: Since 9/30/05: 0% Sep. vs. Aug.: 0%
Comments: Should be a reasonably quiet month given that they usually don't report until the middle of the quarter.