A Unified Theory of Search, Social Networking, Structured Blogging, RSS and the Active Web
The web has traditionally offered a very passive experience: If you want something, you have to go get it. Sure, there are lots of interesting information and useful services out there, it’s just up to you to figure out where they are and how to use them.
RSS is exciting because it is the first widely accepted (and increasingly deployed) standard for transforming the web into more an active entity. With RSS, you can now “listen” to the web and automatically receive updates without having to go looking for them. But RSS is primarily a demand-side innovation. It benefits consumers of information/services but not suppliers.
The real innovations yet to emerge are coming on the supply side of web. And they are coming into being primarily as a result of the confluence of three important trends: social networking, search, structured blogging.
Much More Than Dating
I must admit, while I have written about social networking in the past, I really didn’t understand its potential significance until a few months ago. I am not talking about the 1st generation “Do you know who I know?” sites such as Friendster and Orkut, but about the second generation “hang out” spots such as MySpace and Facebook. Up until recently I had pretty much pigeon-holed such sites as just 2nd generation online dating sites.
While this is probably a valid short term characterization, these sites are likely to evolve over time into something more substantial. Specifically, these sites (as well as sites such as MSN’s Spaces and Yahoo’s 360) are highly likely to evolve into an all encompassing digital identify for each user. People will use these sites not just as a way to socialize, but as a hub to manage their broader digital identify on the web. Part blog, part digital cubby hole, these sites will provide each human being with a digital homestead from which they can manage their entire digital identify on the web.
In the early 1990’s, if you had an e-mail on your business card you were regarded as a either a nerd or a curiosity, yet 10 years later almost everyone in the developed world had an e-mail and in many cases used it as their primary means of asynchronous communication. Today people with their own websites are regarded as either curious or vain, yet I feel quite confident saying that 10 years from now everyone in the developed world will have their own website and the few that don’t will likely be regarded as hopeless Luddites much like those without e-mails are today.
Supply Side Economics
With every person in the world managing their own digital homestead, the supply side of the web starts to look very, very different especially when one adds in two key elements: structured blogging and search. Structured blogging is a fairly recent movement which seeks to promote the use of standardized XML-based tags in blog posts so that search engines can readily recognize both the type of blog post and the individual elements within it. For example, if a blogger is writing a product review, the structured blogging tags would enable a search engine to easily identify that particular post as a product review and even to identify the specific product. Essentially structured blogging would allow search engines to take the guess work out of vertical search. It would also allow search engines to easily incorporate blog posts into their database platforms (such as Google Base). It is only a matter of time before structured blogging (or some variant of it) is embraced by not just every blogging platform, but by every social networking site. What this will result in is a huge amount of index-ready supply side information.
This is where search comes in. Using their spiders the search engines will now index and assimilate into their newly minted databases all of this structured supply side content. The results will then be available to the entire world within hours.
Your Own Global Megaphone
People’s behavior will change radically once they realize that they can publish all forms of structured content on their own websites that will, within hours or minutes, be indexed and made available to the entire world by search engines and structured databases. For example, why go the trouble of posting an apartment for rent on Craig’s List or Rent.com when you can just publish a “Apartment Rental” post on your personal website and know that this listing will shortly be available to everyone in the entire world, not just via search engines but via the specialized listings sites that the search engines will create to display such content. It’s like having the biggest megaphone in the world at your personal disposal for any and all of your requests or desires.
Through the combination of social networking’s personal websites, structured blogging, and search, the supply side will essentially become a “write once, distribute everywhere” proposition. No need to wander around the web trying to figure out how best to reach other people, just publish once on your site and let the “Active Web” take the information and distribute it as widely as possible.
Of course, there may be some information that you are not wild about sharing with the world, such as a dating profile or a job resume, but that is an easily solved problem because users can simply specify which search engines are allowed access to their content. It is not hard to imagine a personal website 5 or 10 years from now that has a different tab for each major type of structured content. On each of these tabs will not only be the structured content itself, but also check boxes that allow users to prevent different search engines from indexing their content. So if there’s a particular database you’d rather not have your resume end up in, you can just exclude that search engine from accessing your resume “tab”.
The Advent of the "Active Web"
RSS and its extensions on the demand side, combined with structured personal (and business) websites and search on the supply side will transform the web from a passive entity into the Active Web and will comprise the first major step towards a more autonomous web that adds real value to people’s daily lives without requiring constant effort and input.
There was a story about me leaving Celsius Capital yesterday in Private Equity Week. It’s actually pretty old news, but I've gotten a bunch of e-mails on it so I thought I would elaborate a bit on the article.
First off, I not only remain good friends all the guys at Celsius but I also remain an ardent supporter of and a close advisor to the fund. It was a blast working with all of them and we are hopefully going to figure out some ways to work together in the future.
We set up Celsius in Q1 of last year to raise an early stage VC fund that invested in both China and US and tried to exploit what we saw as the "investment arbitrage" opportunities that exist between the two markets. I was going to handle the US end of things while my partner Carlos Bhola, who had been investing in China since 1998 and had some huge hits there, would handle China (ably assisted by my former colleague at Mobius, Tony Lo).
So we went out on the road and talked to lots of LPs both in the US, Europe and Asia. While we were able to meet with many of top LPs (thanks almost entirely to Carlos' tireless efforts) one consistent refrain we kept getting from them was that our multi-geography focus was an issue for them. It was an issue from an investment analysis perspective in that they were never quite sure which of their investment teams we should meet with: the US team or the Asian team (invariably they went with the Asian team) and it was an issue from a philosophical standpoint in that many LPs consider multi-geography funds to be tougher to manage given the time and space separating the partnership. Truth is, we all knew this was going to be an issue going in, but we believed strongly in our investment thesis and wanted to give it our best shot.
After about 4 months fundraising though, it became clear to us that while trying to raise a first time VC fund is hard enough, we were going to have a particularly long battle trying to sell LPs on the merits of cross-geography, first time fund. What's more, the idea of a very long fundraising process was particularly unappealing given that we had a rapidly growing pipeline of very promising investment opportunities, especially in China.
Given all this, it was clear to both Carlos and I that we had to focus the fund primarily on one country to eliminate LP concerns and give Celsius the best shot at success. I pushed hard to focus the fund primarily (but not exclusively) on China for a variety of factors not the least of which were the strong team we had built there, Carlos’s record of achievement and the pipeline of promising investment opportunities. Carlos reluctantly agreed not because he thought it was the wrong decision, but because I suspect he knew that I was essentially writing myself out of the script. After all, while I am fascinated by China, I have no investment experience there, no language skills, and no professional interest in investing primarily in China. In addition, neither my wife nor I are interested in moving our family to Shanghai, so that kind of sealed it.
So based on these factors, last summer I officially and very reluctantly took my name off the masthead of Celsius. While it was the right, intellectually honest, decision for the firm, it was a tough one for Carlos and I because we really enjoyed working together. Fortunately, we told the LPs we were meeting with about the change and it was well received as it made the investment much easier for them to categorize, evaluate, and allocate to.
It’s now more than six months later. Celsius is still doing well and in addition to making some new investments should hopefully close its first formal fund in the near future. After a couple months off, I have been working on a new US-based fund and I am looking forward to eventually finding a way to work with Celsius.
So, not that anyone really cared, but that’s the full story.
Burnham’s Beat Reports Record Q4 Revenues
Silicon Valley, CA – (BLOGNESS WIRE) – Jan. 11, 2005
Burnham’s Beat today reported record results for its fourth quarter ended December 31, 2005. Revenues for Q4 2005 were $168.64 up 176% compared to $61.08 in Q4 2004 and up 27.3% sequentially vs. Q3 2005. Earnings before expenses, which management believes are the most cynical results we can think of, were also up 176%.
Commenting on the results, Bill Burnham, Chief Blogger of Burnham’s Beat explains “This quarter’s results continue to demonstrate that blogging is a complete waste time. While we did not achieve our previously forecasted results of 100 billion page views and ‘Google-style cash, Baby!’, we remain hopeful that people forgot about those projections. There are several reasons for missing our projections including an outage of our hosting provider in late Q4 which cost us a least $1.00, the continued poor quality of the writing on the site, high oil prices, several deals that slipped to next quarter, and uncertainty created by the war in Iraq. ”
Page views were up 921% in Q4 2005 to 71,772 compared to 7,028 in Q4 2004. However advertising click-through rates declined from 0.78% in Q2 2004 to 0.23% in Q4 2005. In addition, revenue per click fell 56.3% to $0.49/click compared to Q4 2004’s $1.11/click. Commenting on these statistics Burnham added “We continue to believe that page view growth and advertising revenues have been adversely impacted by the switch to “full text” RSS feeds that we implemented in Q3, but we are too lazy to do anything about it. We added an additional search advertising partner in Q4 and were generally disappointed with the results. While revenue per click is higher at this partner, overall click through rates are much lower. In terms of our main advertising ‘partner’ we have seen a clear pattern throughout the year of them reducing the revenue share they pay to their blog-related ‘partners’. Apparently they aren’t making enough money as it is and need to stick it to the little man.”
Revenue per post was $9.92 in Q4 2005 compared to $6.11 in Q4 2004. “Revenue per post indicates that we could pretty much write about paint drying and search engines would still drive enough random traffic to our site to make a few bucks.”
Affiliate fee revenues were $33.91 in Q4 2005 up 963% vs. $3.19 in Q3 2005. Burnham notes “We launched our affiliate fee division in Q1 of 2005. This unit performed poorly until we decided in early Q4 to blatantly pander to affiliate revenues by using sensationalized rhetoric and better placement, a tactic which appears to have worked well.”
Pro-forma expenses were $44.85 up 67% in Q4 2005 vs. Q4 2004 primarily due to switching from the basic $8.95 hosting package on Typepad.com to a $14.95 “advanced user” package which management has yet to really figure out how to use but it would be embarrassing to tell a fellow blogger that they were still using the “basic” package as only newbies do that.
Readers are reminded that Burnham’s Beat’s financial results exclude all labor, connectivity, and capital expenses, all opportunity costs of actually doing something useful, and the considerable goodwill charges that result from constantly antagonizing people by badmouthing their company/industry/personal views. Including these expenses Burnham’s beat would have reported earnings of approximately -$1,000,000,000 but management does not believe that these actual results fairly reflect the alternate reality in which we currently exist.
Burnham’s Beat is comfortable with its previous guidance of
100 billion page views and ‘Google-Style cash in 200
56, Baby!” and hopes
that people remain forgetful.
Burnham’s Beat and Subsidiaries
Pro-Forma, Pro-Forma Preliminary Restated Unaudited Results
|Q4 2005||Q4 2004|
P.S. Yes these are the actual numbers.
The Walled Garden “Hit List”
In my last post on this topic I discussed how search and entities such as Google Base will put tremendous pressure on many of the Internet’s “walled gardens”, in this promised follow-up I examine some of the specific “gardens” that are most at risk.
In yet another priceless scene from Monty Python’s Holy Grail, a group of French Knights, after being informed by King Arthur that he intends to take their castle by force, listen intently to ominous (and somewhat silly) sounds emanating from a nearby forest. The sounds appear to indicate that a massive siege machine is being constructed behind the trees, but rather than race around preparing for the inevitable assault, the French just listen, as if transfixed by the sounds of their own impending doom.
Much like the French knights, today’s “walled gardens” have also been similarly, although indirectly, warned by the big search engines. Indeed, it would seem as though with each passing week the drumbeat of ominous sounds emanating from “search forest” is getting louder and louder, yet most walled gardens do not appear concerned. By themselves, initiatives such as Google Base, directed search, RSS feeds, and structured blogging, do not represent a “killer blow” to walled gardens, but taken as a whole they clearly have the potential to cause major damage.
Just how vulnerable a particular walled garden is to the coming assault depends on three key factors:
- Content Availability: Generally speaking, the more “self published”, publicly index-able data there is, the more vulnerable the walled garden. As I mentioned in my prior post, 10 years ago very few people/businesses had their own web site. Today, the situation is dramatically different with most businesses and an increasing number of people having their own sites. Almost all of these sites are not password protected and can therefore be fully indexed by search engines. If a Walled Garden is charging to distribute or provide access to data that can now be easily aggregated from “self published” web sites, it is in an increasingly tenuous position.
- Index Affinity: The more willing a data owner is to make their data available for indexing, the more tenuous the walled garden’s business. In most cases data owners are quite content to disseminate their information as widely as possible, however there are some cases where limited distribution of data is preferable.
- Process Simplicity: Walled gardens can create value by not only aggregating and displaying data, but also by providing a process for acting on that data. The more complex the process, the more value the garden is adding to the overall transaction. Conversely, if a garden has a highly simplistic process where it simply displays aggregated information, it is highly vulnerable to search led attacks.
Given these three factors, I thought it might be intellectually provocative to assess just how vulnerable some of the biggest “walled gardens” are to search-led assault.
This potential “hit list” includes:
Description: Homestore.com’s main business is operating Realtor.com, the biggest real estate listing site on the Internet. Realtor.com is official site of the National Association of Realtors and has a direct connection into the NAR’s Multiple Listing Service (MLS) which has for some time been the database “of record” in the residential real estate industry. Homestore also operates sites with apartment and new home listings.
Content Availability: Very high. Almost every real estate agent now operates their own site independent of Homestore/Realtor.com. What’s more, these sites tend to offer richer content with longer descriptions and more pictures than Homestore/Realtor.com.
Index Affinity: Very high. Sell side realtor’s (and owners) want the widest possible distribution of their listings.
Process Simplicity: Very high. Homestore/Realtor simply aggregates and displays listings and offers no real process other than basic search.
Comments: Homestore/Realtor.com appears particularly vulnerable to attack. It is quite possible that search engines can create not just a similar but a superior site thanks the large amount of high quality content that is readily index-able and the crazy realtor-friendly data restrictions that Homestore abides by. Thanks to the NAR affiliation, search won’t put Reator.com out of business, but it will put tremendous pressure on its current business model.
Monster Worldwide (MNST)
Description: Monster Worldwide is the largest job and resume listing site on the Internet. Monster charges employers to either post open jobs or search their database of resumes. Consumers are allowed to search the site for jobs and post their resumes for free.
Content Availability: Very High/Very Low. Availability of job listings on individual company sites is quite high as evidence by new competitors such as SimplyHired. However, availability of consumer resumes is very low. Few, if any, consumers currently publish a formal resume on their own websites.
Index Affinity: Very High/Medium. Employers want (and in many cases the law requires) wide distribution of their job listings. On the resume front, while consumers want their resumes distributed, many don’t want them distributed too widely for privacy reasons.
Process Simplicity: High/High. Monster really just aggregates and structures job postings and resumes. They do have some value added processes that enable consumers to quickly apply for a job and more efficiently match companies and prospective employees, but most of the time the next step in the process is just a phone call/e-mail.
Comments: Monster is interesting in that one part of its business (job postings) is clearly very vulnerable in the short term, while the other (resume listings) is not. They will likely have to figure out ways to leverage their resume franchise to protect their job listings.
Description: EBay is the world’s largest online auction site. EBay has also been aggressively moving into the pure classified space by purchasing properties such as Rent.com. While many people think of Ebay as an auction site, almost 1/3 of its items are now sold via its “Buy It Now” feature which operates more like a traditional store.
Content Availability: Low to Medium. Unlike jobs or houses, it currently makes no sense to list an item for auction on a personal or company website given that there is little chance that a personal site will attract a large number of potential buyers. However, there are lots of items on the web for sale at a fixed priced.
Index Affinity: High. Like most sellers, EBay’s sellers want the largest possible audience for their items and so are quite open to any marketing strategy that could increase their sales. Individual E-Commerce sites are increasingly letting their inventory be indexed for exactly this purpose.
Process Simplicity: Low. Facilitating an auction is a complex process, especially compared to something like listing a job or house. EBay tries as hard as it can to stay out of the process, but still is much more involve than the average walled garden.
Comments: While EBay’s pure auction business seems fairly well insulated from search-led attacks, the “Buy it Now” business seems much more vulnerable. The merchants that sell via the “Buy it Now” button are really just using EBay as a distribution channel and, would likely rather sell direct to customers via their own e-commerce website than pay EBay their commission if they had a lower cost option. The issue then comes down to whether or not EBay is a cheaper distribution channel than search. To date, my anecdotal conversations with many online sellers indicate that search is, net net, a cheaper channel but the difference is narrowing as the cost of search words increases. This equation would be blown apart though if Google were to index,structure and present e-commerce items for free, as opposed to the flawed Froogle/Dealtime/Shopping.com model it currently uses. Ebay’s recent foray into classified ads, such as Rent.com, seems especially ill-timed as they would appear to have the same vulnerabilities as Homestore.
Match.com (part of IACI)
Description: Match.com is the largest online dating site. Users submit profiles and pay monthly subscription fees to contact each other.
Content Availability: Low. While an increasing number of potential Match.com customers have their own web page at places such as MySpace.com or Facebook.com. the idea of posting one’s dating profile on one’s homepage (at least overtly) has not yet really taken off. This will change over the long term, but there’s no readily available content for the search engines to index right now.
Index Affinity: Low to Medium. People looking for a prospective mate usually want to maintain a modicum of discretion in their endeavors and thus are probably not going to be wild about random search engines indexing their personal details and then broadcasting them to the world. That said, if they had control over which engines indexed them people might be more inclined to participate.
Process Simplicity: High. As currently structured online dating sites offer a very simple process: search, look, e-mail. Some try to distinguish themselves by offering a screening or qualification process (such as a personality test), but most are really just glorified “personal” sections.
Comments: Online dating sites, such as Match.com, seem relatively safe from the Google’s of the world in the near term thanks to the lack of index-able content and the need for discretion. The real threat to the online dating sites is coming from the social networking sites which should seize a large piece of the dating market from the current walled gardens over time.
Fight Them or Join Them?
While some of the walled gardens are well and truly doomed, others still have time to respond before the search-led assault commences. Responses can (and should) vary. The most radical option would be for the walled gardens to tear down their walls and try to beat the search engines to the punch by launching their own vertical search plays. The gardens are highly unlikely to do this though because it would result in massive near term revenue and margin disruptions. Another strategy might be to buy some of the independent “vertical search” players targeting their specific market niche and then operate them as a separate business. This way they can hedge their bets and cover both bases. A third strategy might be to merge with some of the existing search players in advance of their entry. This could make sense for both players as it would assure continued domination of the particular market niche, however it may be hard to make the numbers work.
Whatever the case, those sounds emanating from “search forest” are not the sounds of a giant wooden rabbit being built, but of a kick-ass, take-no-prisoners structured search machine. The walled gardens would be wise to get off the wall and starting preparing for the inevitable assault.
Top 5 Most Shorted Software Stocks
Following up on a quick post I did on the Top 5 Internet Stock Short Positions at the end of 2005, I thought I would do the same analysis for the Software Sector. It's interesting to note that most of the shorts are mid/small cap stocks even though large cap software stocks were some of the biggest losers last year.
To figure out just how short a stock is, I am taking the reported number of shares sold short as of mid-December and dividing it by the float (which is basically total shares out less insider shares). Here are the Top 5 Software Shorts as of the end of 2005:
- Clickcommerce Ticker: CLCK
% of Float Short: 41.4%
P/E: 16.2 Market Cap/Tangible Book: 31.0
Comment: Kind of strange to see this stock so short given its low P/E, but apparently the pros think the earnings are bogus and a day of reckoning is coming. Better come soon though as the stock was up 30%+ last year.
- Rightnow Ticker: RNOW
% of Float Short: 29.6%
P/E: 103 Market Cap/Tangible Book: 15.3
Comment: One of the few public SaaS stocks and one that has a large % of the stock still owned by insiders. Looks like some pros don't buy the SaaS hype as the short position on this stock more than tripled last year. I met the CEO and he doesn't seem like the type of guy to sell, so insider selling is not going to bail out the shorts here, it's going to have to be poor performance.
- TakeTwo Interactive Ticker: TTWO
% of Float Short: 21.6%
PE: 31.6 Market Cap/Tangible Book: 3.3
Comment: Maker of Grand Theft Auto series guilty of stealing from it's shareholders in the form of a 49% decline in it's stock price in 05. Pros apparently think the worst is yet to come as there are still over 15M shares short.
- Microstrategy Ticker: MSTR
% of Float Short: 21.5%
PE: 20.5 Market Cap/Tangible Book: 7.4
Comment: A long time short favorite thanks to numerous run-ins with the SEC. Pros obviously think "once a crook, always a crook". I am actually long this stock which means I am pretty stupid and/or very forgiving, we will see!
- Convera Ticker: CNVR
% of Float Short: 20.4%
PE: NA Market Cap/Tangible Book: 10.2
Comment: Enterprise search vendor that has shrewdly surfed the Google hype by announcing a series of web-based search initiatives. My pick for "most likely to screw the pooch" in 2006.
Top 5 Most Shorted Internet Stocks
Starting off the year I thought it might be interesting to review just which Internet stocks have the biggest short positions on them. Short positions are typically taken by professional investors so looking at the Top 5 Short Positions is a good way to get of sense of just which stocks professional investors dislike the most.
Each month the stock exchanges publish the number of shares sold short in a particular stock. If you compare the number of shares short to the total float (basically total shares less insider shares) it's a good measure of just how "short" the stock is . As of the end of 2005 here were the Top 5 Internet Short Positions:
- Overstock.com Ticker: OSTK
% of Float Short: 59.8%
PE: NA Market Cap/Tangible Book: 6.9
Comment: The shortest of the shorts. Overstock's CEO has been having a very public and highly amusing battle with short sellers which, thanks to the increasinly poor performance of the company, he appears to be losing. Not only was Overstock was one of 2005's worst performing Internet stocks, but Overstock gave short sellers a belated Christmas present when they preannounced shortly after Christmas. Sometimes the pros are right.
- Netflix Ticker: NFLX
% of Float Short: 38.7%
PE: 68 Market Cap/Tangible Book: 11.7
Comment: Then again, sometimes the pros are wrong. Despite a very strong short position all last year, Netflix closed out the year as one of the best performing Internet stocks thanks to an improved financial and strategic position. The pros appear to think that Netflix is still destined to come back to earth, but it is clearly in a lot better shape than something like Overstock.
- J2 Global Communications Ticker: JCOM
% of Float Short: 22.2%
PE: 21.7 Market Cap/Tangible Book: 7.0
Comment: The king of e-faxing which owns such websites as Efax and Onebox has seen its short interest increase substantially throughout all of last year apparently as people bet that faxing will go the way of the quill pen. (I for one will never fax another document after figuring out how to just scan and .pdf them).
- Digital River Ticker: DRIV
% of Float Short: 21.9%
PE: 24 Market Cap/Tangible Book: 11.6
Comment: Short interest in this stock more than doubled in 2005 and yet the stock was only down 15% or so. Looks like the pros are still expecting a big downside move.
- Priceline Ticker: PCLN
% of Float Short: 19.9%
PE: 16.9 Market Cap/Tangible Book: 49.6
Comment : It's kind of ironic that both Priceline's customers and a lot of investors are all hoping to get a lower price but aren't sure what will happen. While short interest is still high, it was almost twice as high at the beginning of last year, so many of the pros have clearly given up on this short already.
Virtual Stock Portfolio: Year End 2005 Review
The Burnham's Beat virtual stock portfolio closed out 2005 on a strong note up 4.6% in December vs the Nasdaq's 1.2% decline. Q4 turned out to be a great quarter after I spent some quality time in late September updating what had become an admittedly dated portfolio. Its 16.5% return was the second best quarterly return since inception. Overall, 2005 was another good year for the portfolio as it was up a total of 37.1% vs. the Nasdaq's 1.4% gain. This brings the total gain since the portfolio's inception in Freburary of 2004 to 84.0% vs. a 2.4% gain for the NASDAQ over the same period.
I only held one position the entire year and that was a short position in Wave Systems (+38% return on the year). Other than that the entire portfolio turned over during the year. My biggest gainers in 2005 were Neteller (Long, +116%), SportingBet (Long, +56%). SPSS (+53.5%) and Microstrategy (Long, +52%). My biggest losers were Autonomy (Short, -109%), Salesforce.com (Short, -39%), FireOne (Long, -13%) and my first trade in Actuate (Long, -5.9%). Overall, 74% of my positions were positive which is pretty respectable. I did end up shorting two of the year's best performing software stocks (Autonomy and Salesforce.com) but at least I limited my losses by selling out before they really hit their strides.
Repeating 2005's performance will be pretty difficult in 2006, but if the market stays choppy it should be continue to be a good environment for picking stocks. To start off the year I am getting out of a few positions that seem to have run their course. The first is the paired trade between Party Gaming (long) and SportingBet (short), by the end of 2005 the multiples of these two stocks had basically converged so its time to unwind this trade and move on. I am also getting out of my short position in Emerge Interactive. The company seems to have stablized a bit and I don't want to be too greedy as they have plenty of cash left. I am also exiting FireOne group, one of the online gambling payment processors. I just can't justify holding this stock when it trades at a premium the #1 player in the space (Neteller) despite lower margins and growth rates.
I am not replacing these positions this month, but will add a few more positions next month after the market settles down for the year.
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. Businesses are still spending big bucks on BI and MSTR should be a big beneficiary.
Performance: Since 3/31/05: +52.3%, Dec. vs. Nov.: 11.9%
Comments: Nice month and still chugging along despite a big short position. I am bit concerned that the stock will start to sputter now that they are tapped out from a buyback perspective, but they should report a decent Q4 and the stock will soon start to trade off of 2006 which reflects all the buybacks.
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.
Performance: Since 7/31/05: -13.3%, Dec. vs Nov.: -0.1%
Comments: Closing this position out after the market has moved to such an extent that Neteller (the #1 player in the market and an old long pick) now trades at a discount to Fireone despite the fact that FireOne has lower margins and growth rates. If I were going to own any stock in this space now it would Neteller not this one.
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: +24.1% Dec. vs. Nov.: -4.8%
Comments: Cooled off a bit in December, after busting through $3/share without a problem. If they exceed estimates this quarter it could move past $3.50.
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: +0.9 % Dec. vs. Nov.: -5.6%
Comments: Weak in December, should recover in January (if it doesn't preannounce!).
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: 11.6% Dec. vs. Nov.: -2.5%
Comments: I have been following the online gambling sector closely for the past two years and right now I really think that CRYP offers the best risk/reward of any of the stocks. It trades at the lowest EPS multiple in the group right now (14X 2005) which is about a 30% discount to where the rest of the group now trades. This despite the fact that CRYP is one of the only online gambling stocks to trade on a US Exchange and has a very diversified revenue base. This should be trading at least 25% higher.
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 116p 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%. 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: +36% Dec. vs. Nov.: +14.5%
Comments: This trade worked like a charm. During Q4 party was up 43.4% and Sporting Bet was up only 7.2%. The mulitples have now converaged, at least from a market perspective, so it's time to close this trade out and move on. I actually believe that Sportingbet trades at a much higher multiple than the market seems to think (I would not be long the stock this year), but you can't fight that battle in a paired trade.
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: +25.3% Dec. vs. Nov.: 15.0%
Comments: This company amazes me. It makes CDSS look IBM, yet WAVX continues the ward off the grim reaper by raising more money. Not that raising money is that hard when you issue fully registered shares at a 26% discount to the market with 18% at the money warrant coverage. It's ridiculous the SEC let's companies do this without forcing them to make a rights offering. What a scam. Anyway, they were only able to issue about $3.5M in shares in mid-December which buys them less an full quarter at their current $4M+ burn rate. Perhaps 2006 will finally be the year of reckoning for Wave.
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. 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: 48.3% Dec. vs. Nov.: 35.4%
Comments: I am going to be greedy and hold this 1 more month. The management team all got employment agreements at the end of the month which means a sale is probably just around the corner. They are running on fumes right now and nothing else. Funny thing is that I think it will sell for at least $20M, but the preferred stock and debt will get all of that.
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: +15.4% Dec. vs. Nov.: -15.8%
Comments: I thought it would be greedy to hold on to this after making 30%+ my first month and I was basically right. Unlike WAVX or CDSS these guys actually have enough cash in the bank to last a few quarters at their current run rate, so the day of reckoning is not upon us and they will be able to spin a lot of "hope and prayer" stories before then that may cause this to back up. Given this, I think I will take my gains and move on to the next rodeo.
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: +13.6% Dec. vs. Nov.: +3.2%
Comments: I can't see why people are paying 28X EPS for this company given the competition it faces and its repeated ability to execute. That said, the stock always seems to float back up after they disappoint, so I think I will probably only stick around another month.
The Incredibly Shrinking Software Industry
At one level, Software seems to be entering its Golden Age, quickly spreading into almost every corner of our lives. TIVOs, iPods, Treos, you name it; they all have a large and growing amount of software in them. Any yet, despite this explosion of new software, the software industry itself is shrinking. In 2005, the aggregate market capitalization of the software sector shank by almost 10% despite the broader NASDAQ market being up 1.4%. Even if one adjusts that number to account for privatizations, M&A and IPOs, the software market still shrank by 9% so there’s no denying that anyway you look at it, 2005 was a bad year for Software stocks.
This shrinkage is also apparent when looks at the raw number of public software companies. There were 236 public software companies at the start of 2005, but only 213 at the end of the year, a decline of 10%. Put another way, for every new software company that went public in 2005, almost 7 were acquired or went out of business. Not exactly an encouraging picture.
What then is responsible for the software sector’s precipitous market cap decline? Like most complex systems, there is no one single factor driving this trend, but a combination of factors including:
- Software is moving from “growth” to “value”. Let’s face it: from an investment perspective software is no longer viewed as a “sexy”, high growth industry by many investors. This change in sentiment has led to what Wall Street calls “investor rotation” as “growth” managers move out and “value” managers move in. One can sense this change in the daily chatter emanating from the market. In the past, much of the market chatter was about license growth and new products, now the chatter seems to center around maintenance pricing and services revenues. More important than chatter though, value managers simply aren’t willing to pay 35X next year’s EPS for anything, which is leading to major multiple contractions in many of the top names in the industry. I personally believe that this is probably the single biggest technical reason that large cap software stocks performed so badly in 2005.
- Open Source and SaaS. The modern software market was built on the backs of large one-time perpetual license sales. Charging significant up-front fees for access to proprietary source code not only allowed companies to post 95%+ gross margins, but enabled successful software companies to delight investors by very rapidly growing revenues and earnings. Sure the whole thing crashed when the company ran out of new licensees, but it was a fun ride for everyone in the market while it lasted. Unfortunately two major trends are conspiring to make it increasingly difficult to grow revenues quickly: Open Source and SaaS. Open Source basically flips the revenue model: it gives away the source code up-front and tries to make money on the back-end by charging for support. Open Source has already put tremendous pressure on revenue growth in areas such as web servers, application servers, and databases, and threatens to do the same in several other places. In response, many traditional “closed source” vendors have reduced their upfront license fees and increased their maintenance charges. SaaS (Software as a Service) allows companies to purchase software “on demand” over the web. As a result, SaaS requires little or no up front investment from a customer and is often purchased on a short term subscription plan. The lack of large up-front payments makes it very difficult to grow SaaS revenues quickly and reduces margins because the company actually provides a real service as opposed to just shipping a disk. Thus, as Open Source and SaaS gain prominence it’s becoming increasingly clear to investors that the good old days of 200% revenue growth/year at 95%+ gross margins are gone for good and stock multiples are responding by heading south.
- No big platform transition. The software industry has traditionally seen its best years in the wake of major “platform” transitions, be it from mainframe to minicomputer, or client-server to n-tier. Each platform transition is typically accompanied by several new “anchor” products that customers must adopt and this adoption tends to drive new revenues. For example, client-server led to departmental databases and client-side apps. N-Tier led to web/application servers. The industry has very high hopes that Web Services will occasion another major platform transition and thus create a lot of value, but as of yet, no “anchor” products have appeared and revenue growth from Web Services has therefore yet to make up for declining n-tier related growth.
- Networking companies are encroaching on software company turf. If you pry open the hood of your average router, you won’t find a disk drive or a keyboard but you will find a ton of software sitting inside flash memory or embedded in chips. In fact, many network company executives will insist to anyone that listens that their company is more of a software company than it is a hardware company. This really didn’t matter when the “software” that the networking companies built was totally focused on making their devices work better, but increasingly networking companies are focusing on making their devices “application aware”. To be application aware, these devices basically start to take on capabilities, such as data analysis, workflow, etc., that have traditionally only been handled by “normal” software companies. Thus, this rise of application aware networking could likely to siphon off revenues from the traditional software industry. This really isn’t happening yet, but the market is starting to get a sense that this might happen.
- Being public ain’t so great. Being public in these post Sarbanes-Oxley days is not easy, especially if you were a software company that lavished options on its employees and played it a little loose with revenue recognition from time to time. Like most tech companies, software companies are seeing their margins hurt by higher compliance costs and steep charges for options. Because software companies have relatively high margins on low revenues, these incremental operating expenses tend to have a bigger impact on overall margins. What might cost a hardware company with $10BN in revenues 50 basis points of net margin costs a software firm 200 basis points, so the impact can seem to be a bit disproportionate.
Despite these trends, the software industry will still survive and may, at some point, begin to thrive again. Areas such as web services, mobile computing, semantic analysis, storage management, message aware networking, Chinese software and virtualized computing (to name just a few) hold significant promise for future growth, but that growth will have to occur despite the long-term headwinds posed by the trends outlined above.
Software Stock Update: 2005 Year In Review
When I first compiled the statistics for this post, I did a doubletake and thought to myself "there's no way the market cap of the software space shrank by almost 10% last year!?!". So I went back and double checked and sure enough it did. Yes indeed, that giant "poof" sound you heard last year was almost $85BN in software market cap, or 10% of the total, going up in smoke.
Compare that to the 1.4% gain for all of NASDAQ and you start to wonder "What the hell happened?". The most direct reason was that large cap enterprise software stocks almost uniformly declined last year, most by double digits. IBM led the way in the value destruction parade by sheding over $34BN of market cap followed by Oracle which shed $18BN despite swallowing Peoplesoft during the year. MSFT chipped in a comparatively modest $12BN while the combined SYMC/VRTS shed an astounding $9.5BN or about 33% of its market cap. In fact the only large cap software stocks that managed gains were SAP and Adobe. Everyone else was in loss city. Small caps managed to do modestly better with the average stock posting a 1% increase, but clearly the software sector as a whole had a very bad year.
What drove these precipitous market declines? There are many factors at work and I started to write them all down, but I think I will save them for a separate post as the topic certainly deserves deeper discussion.
In the meantime, feel free to download the attached spreadsheet here as it has all of the end of year prices as well as the average multiple for each major sector and a list of all the IPO and M&A events. If you want to update the prices of the stocks in this spreadsheet automatically, click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.
Top 10 Worst Performing Software Stocks of 2005
The competition was fierce, the nominees were numerous, but in the end 10 lucky stocks finally won out to become The Worst Performing Software Stocks of 2005. There was no clear theme among the losers other than "there is no excuse for not making money and if you are not making money at least don't spend it like a bunch of drunken sailors."
To qualify for this year's race all a firm had to do was start the year with at least $50M in market cap and focus its business on trying to sell software.
And the winners are:
- Citadel Security Systems
Price Change: -88.1% Ticker:CDSS
Comment: Provider of threat detection security software apparently didn't detect the threat all those losses had to its balance sheet. Investors punished the stock accordingly. Look for a quick sale in 2006.
Price Change: -82.2% Ticker:BVSN
Comment: A failed private buyout combined with continued losses and an upside down balance sheet have pushed this web software pioneer to the brink of filing Chapter 11. Some kind of restructuring has to take place in '06 if this company is going to survive.
Price Change: -72.8% Ticker: MOTV
Comment: Investors were highly motivated to sell this stock when it continued to disappoint throughout 2006 thanks to saturation in its core markets.
- Emerge Interactive
Price Change: -72.3% Ticker: EMRG
Comment: This developer of supply chain software for the cattle industry is headed for the slaughterhouse shortly unless it can scare up some more revenue pronto.
Price Change: -68.8% Ticker: ADAT
Comment: This provider of digital watermarking and a few other random technologies finds itself trading close to tangible book after 3 years of increasing losses and no clear strategy to reverse them.
- Innodata Isogen
Price Change: -71.8% Ticker: ARBX
Comment: Content management company has seen stock price slide along with revenues.
Price Change: -64.1% Ticker: SNDA
Comment: Provider of 3D "internet marketing technology" software that apparently isn't visualizing how to sell very well these days.
Price Change: -64.0% Ticker: VERT
Comment: Just another amazing effort by the team at VERT. After 2000's 95.9% decline and 2002's 94.4% decline, it's just amazing to see them turn in another Top 10 performance. They deserve a lifetime achievement award.
Price Change: -60.8% Ticker: ACTI
Comment: Provider of security tokens with a $150M in cash and a market cap just barely above tangible net worth. My guess is if they stopped spending cash and started growing revenues things might be different.
Price Change: -55.7% Ticker: ARBA
Comment: Pioneer of spend management software got the market's answer on whether or not its merger with FreeMarkets was a good idea. The answer was "no".