Burnham's Beat

Software Stock Picks and Pans

Here’s a list of the current long and short picks in my virtual software stock portfolio. As of April 30th, the overall portfolio was up 8.4% compared to a 9.8% decline in the NASDAQ Composite. Not surprisingly, the best performing picks were the short ideas while the long picks were typically weak, although only one pick underperformed the market. The overall performance of the portfolio would have been a lot better if it was not so strongly net long (33% net long), but to be so long and still have beaten the broader market by 19 points so far this year is not bad, so I will take what I can get.

These stocks are just a small subset of the 255 public stocks that I follow in my software stock spreadsheet. From a long perspective, I try to look for stocks that are trading at attractive market cap/tangible book and enterprise value/sales ratios in sub-sectors that are experiencing good growth. I particularly like stocks that are losing a small amount of money but are just about to turn the corner and become cash flow and EPS profitable. On the short side, I pretty much look for the inverse: stocks that trade a very high book value and sales ratios and companies that are in sectors with difficult market dynamics with leaders that appear to be in denial.

While I am already very long, I find myself coming up with more and more long names as the market continues to let off steam. That’s fine, but there are still some good shorts out there so I need to spend some more time developing short ideas. I also want to start informally pairing my trades within sub-sectors as I have observed real “reversion to the mean” behavior in a number of sub-sectors and want to try and capitalize on it.

Details on the specific stocks:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: Actuate is a relatively cheap name in the white hot business intelligence space. I like the BI space in general because the amount of data companies are collecting is increasing dramatically and they see BI tools as a way to leverage all of their data collection efforts. Actuate itself is by no means a leader, but the stock seems to have been unfairly punished relative to other BI plays. In addition, ACTU has a number of new products coming to market which should help license sales. I also like the fact that Actuate is right around break even and should become EPS positive in a quarter or two. At 1.4X enterprise value/sales it’s relatively cheap to the rest of the sector which trades at 2.0X.
Performance: Since 1/26/04: -7%, Mar vs. Apr: +4%
Comments: While it has performed slightly better than the market, ACTU has still been a disappointment, however I am optimistic that the stock will trade up in the next couple quarters once the company turns EPS positive.

Company: Blue Martini Ticker: BLUE
Sub-sector: Vertical Solutions
Investment Thesis: Blue Martini started out life as a middleware player but has since focused on a set of applications to help manage sales and marketing activities. The stock has been hammered from its high of over 400 in the heydays of 2000 and now trades a very attractive 1.5 market cap/tangible book and only 0.3X enterprise value/sales. These discounts are somewhat warranted given that difficulty of transitioning from infrastructure to application sales, but the company has been making slow, but steady, progress reversing its losses. It doesn’t have a lot of competition and could conceivably break even early next year which would like result in a big run in the stock.
Performance: Since 1/26/04: -6%, Mar vs. Apr: -7%
Comments: This is probably the long pick that I have the least conviction on right now due to the unproven nature of its new product lineup, but at 1.5X tangible book I don’t think I have a ton of downside. I am monitoring this closely but I will continue to hold on for now as it could easily trade up to 1X EV/Sales if it breaks even.

Company: SumTotal Ticker: SUMT
Sub-sector: E-Learning
Investment Thesis: Sumtotal was formed by the merger of Docent and Click2Learn which closed in mid-March. I liked Docent before the merger because it was relatively cheap, had good products, and was in a space still seeing good corporate spending (E-Learning). The combined companies promise to be solidly profitable after the debris from the merger clears which should help the companies overall valuation and help cement their leadership position in the e-learning space. Generally speaking I don’t companies that are going through big mergers, just too much to go wrong. However, this merger should take two companies that were slightly unprofitable and make one solidly profitably company which I like.
Performance: Since 1/26/04: -13%, Mar vs. Apr: -15%
Comments: The stock had a terrible April (and first week in May hasn’t been great either), but I am going to stick with this and see how their Q2 and Q3 numbers come out. Q1 numbers were clouded by a bunch of merger related charges and while the company still had negative cash flow, it was only $1M. I expect Q2 to see positive cash flow and Q3 positive EPS, both of which should benefit the stock.

Company: SPSS Ticker: SPSSE
Sub-sector: Business Intelligence
Investment Thesis: I added SPSS to the portfolio at the beginning of May. SPSS is another 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. As the “E” at the end of the ticker suggests, SPSS is in danger of being delisted because they didn’t file their 10K on time due to the accounting problems. The stock trades at an attractive 1X enterprise value to sales. My thesis is that the new product set is strong and the accounting trouble is overblown. In addition, the stock will not be delisted because SPSS is a real company with real revenues ($50M+/quarter) and NASDAQ needs every listing it can get right now.
Performance: Since 4/30/04: NA Mar vs. Apr: NA
Comments: SPSS is off to a strong start in the portfolio up about 9.4% since the beginning of the month thanks to an upbeat Q1 earnings report. This is particularly impressive given what a blood bath the first part of May has been in the market. The stock was slightly up on two of the worst days indicating that big buyers are building positions, so I like this stock in near term quite a bit.

Short Picks
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 based on my VC investment in Stratify. 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’s CEO is the company’s technical founder who has a reputation for being an idealist and bull headed. Not good traits to have in a rapidly evolving market. Autonomy trades at a huge premium to the market at 5.3X enterprise value to sales vs. a 1.8X average for the rest of the content management group. 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 as well as the small float due to its meager cross listing on NASDAQ. It makes it a tough stock to short, but the valuation and market dynamics are just too compelling.
Performance: Since 1/26/04: +21% Mar vs. Apr: +13%
Comments: Autonomy has performed well since January thanks largely to the overall weakness in the market which tends to affect highly valued stocks with poor float disproportionately. Given that AUTN is still trading at high relative values there may yet be some more weakness, but this stock probably won’t go much below 15 due to European investor infatuation with its technology.

Company: Commerce One Ticker: CMRC
Sub-sector: Supply Chain
Investment Thesis: I know CommerceOne well as I was the analyst on their IPO in the summer of 1999. CommerceOne was actually the best performing IPO of 1999 which is saying something. Believe it or not, I think the stock topped out at almost 1200 on a split adjusted basis. However, time has not been kind to CommerceOne and their financial statements tell the tale. The company has lost over $3BN in the last 3 years and while it has reduced the size of the losses, it looks like it will be too little too late. I have watched a number of high flyers implode under the weight of the infrastructures that they built and I think CMRC will succumb to that same fate. With all the institutions long gone, it looks like a bunch of clueless retail investors are currently holding the bag unaware that it contains a ticking bomb. With $12.5M in preferred stock and another $5M in bank lines ahead of the common there’s a good chance that the common stock will get nothing if this company is even sold.
Performance: Since 1/26/04: +47% Mar vs. Apr: +28%
Comments: CMRC has been the best performing pick in the portfolio. April was particularly strong thanks to reality starting to set in on the remaining common holders following a dismal Q1 report in which CMRC booked just $250K in new license sales. Almost all of my startup investments booked more than that! Given the preferred overhang and the continued losses, I think that there’s a decent chance this stock will go to zero in a year or so, but hope seems to spring eternal so there might not be a lot of additional downside in the near term.

Some stocks that had not made the formal cut to become part of the portfolio yet, but which I increasingly like are: Long: Interwoven (IWOV), Stellent (STEL), and Hummingbird (HUMC), E-Loyalty(ELOY) Short: Convera (CNVR)

We’ll see how things turn out next month!

Will Google be Worth More Than Yahoo?

Looking through Google’s S1 filing for its upcoming IPO is an awe inspiring experience. Such impressive financials make it highly probable that Google’s market cap will exceed Yahoo’s when Google goes public later this year. That Google may soon surpass the $35BN market value of Yahoo is especially ironic given that Google has Yahoo to thank for a large part of its tremendous success.

Simply Stunning
In Q1 2004, Google generated operating income of $155M on revenues of $389M which equates to stunning operating margin of 39.9%. Even Microsoft, high-tech’s perennial profitability poster-child, only had an operating margin of 35% in Q1. In contrast, Yahoo generated operating income of $132M on revenues of $758M which equates to only a 17% operating margin. From a cash flow perspective, Google had $204M in operating cash flow for a mind numbing 52.4% cash flow margin. Yahoo generated slightly more operating cash flow of $236M, but its cash flow margin was only 31.1% thanks to its higher revenues.

From a top line growth perspective, Google’s $389M in Q1 revenues represented a 118% increase from last year’s $178.9M. Yahoo’s Q1 revenues grew at a seemingly faster 168% pace from $283M to $758M, but this does not account for Yahoo’s acquisition of Overture. If you add in Overture’s Q1 2003 revenues of $225M, then Yahoo’s growth rate was only about 49%, less than half that of Google’s.

So in summary, Google’s growth rates and operating margins are double those of Yahoo’s and despite having revenues that are just over half the size of Yahoo’s it was still able to generate more operating income and almost as much operating cash flow thanks to its amazing margins. Given the premium that Wall Street puts on high growth and high margins, you don’t have to have be an expert in valuation analysis to know that these numbers almost pre-ordain that Google will have a higher valuation than Yahoo.

A Few Potential Pitfalls
That said, there are a few factors that could conceivably hurt Google’s valuation enough to prevent it from surpassing Yahoo. First and foremost, investors may be highly skeptical that Google can sustain its torrid growth rates and lofty margins, especially in light of increased competition from folks like Microsoft. Second, Google’s business model and revenue streams are highly concentrated on its core business. Any major disruption in the paid-search market will hit Google particularly hard, while many of its competitors will have other revenue streams and business lines to fall back on. In addition, Google’s core search market is unlikely to be able to provide the kind of growth that Google will ultimately need to justify such a lofty valuation. Third, Google’s relative immaturity as a public company combined with its strange IPO process, avowed prohibition on earnings guidance, and shareholder unfriendly governance structure may encourage investors to more heavily discount their future earnings expectations for the company than they might otherwise.

The open question then is whether or not these factors will be significant enough to offset Google’s superior financial performance. To some extent, this question will be resolved by how well Google conducts its IPO road show, but it will also depend on what, if any, competitive developments take place in the near term, as well as Google’s Q2 financial report (which may come shortly before the IPO pricing if the SEC drags its feet). My personal belief after looking through the numbers is that with a reasonable execution of the IPO there’s a very good chance that Google will be worth more than Yahoo. However, if it’s not I suspect that a Google/Yahoo, long/short paired trade is likely to become a staple a most hedge funds overnight.

A Trip Down Memory Lane
Of course, you may be wondering, what’s the big deal? So what if Google is worth more than Yahoo? In the grand scheme of things, isn’t this situation nothing more than a piece of financial trivia? It might have been except for the fact that in many ways Google really has Yahoo to thank for a large part of its success.

Yahoo, as you may recall, started out its life as a simple search engine. As the Internet grew and new opportunities for expansion opened up, Yahoo gradually moved from being just a search engine to being a full fledged portal with all kinds of content and services. The more services Yahoo added, the less important its core search product appeared to become. So much so, that as search evolved from manually compiled site directories to farms of automatic “crawlers” doing full text indexing, Yahoo didn’t even bother to invest substantial resources in developing its own full text search capabilities, despite the fact that this was clearly where the search business was headed. Yahoo’s reluctance to invest in search was likely driven by the popular conception that search was a “loss leader”. It was simply a free service you offered to get people to your site in the hopes of selling them something else. Given that Yahoo already had millions of people coming to its site for things other than search, such as mail and news, it naturally felt that it didn’t have to invest a lot in search because it already had tons of traffic.

This abdication of the search leader crown through underinvestment and corporate neglect created an opening for new start-ups to stake their own claims in the rapidly developing full text search space, one of which was a little known start-up called Google. As it happened, Google’s search algorithms were clearly superior and it soon developed a cult following on the Internet.

Rather than be alarmed by Google’s rapid rise, Yahoo actually decided to outsource their full text search to the young start-up. After all, why spend their own time, effort, and money on something destined to remain an Internet backwater? While Google had been growing quickly prior to Yahoo’s decision, when Yahoo selected Google as its default search engine Google’s growth really started to take off. This can be seen by anyone taking a tour of Google’s corporate headquarters for there is a famous graph on one of the walls there that charts the volume of search traffic on Google's site. Two of the most obvious upward inflection points are when Google became the default search engine on Yahoo’s US site and when it became the default on most of Yahoo's international sites. So not only did Yahoo direct huge amounts of new traffic to Google but it provided Google with a tremendous new credibility in the eyes of the average Internet user.

Creating a Monster
While Yahoo concentrated on supposedly larger opportunities, Google quietly indoctrinated Yahoo’s entire user base in the joys of searching with Google. Even at that point though, all was not lost for Yahoo surely could have purchased Google, but rumor has it that despite Google letting it be known that would seriously consider an offer from Yahoo, no serious offer materialized.

Slowly but surely, many Yahoo users started going directly to Google. As a result, Google’s traffic was growing exponentially and its user base was starting to look like it might even rival Yahoo’s at some point in the near future. But by the time that Yahoo realized it had created a monster it was too late for it to do anything about it. Whereas early on their partnership Yahoo held tremendous influence over Google because it accounted for such a large part of its traffic and growth, just a few years later, Yahoo was a relatively small part Google’s traffic. Worse yet, thanks to the full-on embrace of electronic commerce by businesses around the world and the massive increase in websites, search was rapidly going from being a loss leader to a major cash cow.

Yahoo’s belated realization of search’s importance came far too late for them to have any bargaining power over Google, which now believed that it could not only easily go public but that it’s own business model and focus was likely superior to that of Yahoo’s . Unable to purchase Google at any price, Yahoo ultimately decided to purchase Overture Services, Google’s main competitor in the paid placement market. The rest, as they say, is history.

To Have A Winner You Need A Loser
Given this history, Google really owes a great big “Thank You!” to Yahoo for making three major strategic blunders. The first was Yahoo’s decision to de-prioritize search, the second was Yahoo’s decision to outsource its search to Google, and the third was Yahoo’s failure to use their initial leverage to buy Google early on at an attractive price.

In light of these blunders, the fact that Google may now be worth more than Yahoo must certainly be a bitter to swallow for Yahoo’s shareholders. Not only did they miss out on an opportunity to double the value of their shares, but Yahoo’s own decisions helped created a major competitor which will likely be a thorn in their side for years to come. To add insult to injury, Yahoo’s shareholders can only imagine how valuable their company would be if the management team had not only acquired Google when it was still a start-up but had followed through on their almost completed merger with EBay (which fell apart over trivial management issues). Together these two non-acquisitions may well indeed constitute the biggest strategic failures in the history of the Internet industry.

Perhaps the only Yahoo investor that won’t be disappointed on the day of the Google IPO is Sequoia Capital. Sequoia’s Mike Moritz made his firm’s original investment in Yahoo and he also made his firm’s investment in Google. Given these family ties, it is likely that Sequoia played no small role in getting Google the Yahoo distribution deal. When one realizes that Sequoia has already distributed its Yahoo shares back to its investors, the sheer beauty of their finesse play becomes readily apparent. Having gotten a great return out of Yahoo, they then parlayed their influence at Yahoo into helping Google break-out. It’s as if they hit the jackpot twice playing the same lottery number.

However for the Yahoo’s remaining shareholders, the day that Google’s IPO prices is likely to prove bittersweet at best. What many will remember as one of the biggest technology IPOs in history will, for some, painfully and publicly quantify one of the biggest missed opportunities in Silicon Valley. In this way, the fact that Google will even be worth close to what Yahoo is, let alone more than it, will transcend financial trivia and become a lasting lesson in consequences of strategic miscalculation.

Software Stock Spreadsheet

Attached is an updated version of my Software Stock Excel Spreadsheet with prices for 240 public software companies as of 12/31/04. In addition to a list of current stock prices and key statistics, there are two other sheets. One sheet called "Index" provides a history of prices and market cap for each stock over time so that you can calculate an index for industry. The other called "add/sub" tracks additions and deletions to the list. Deletions are largely due to M&A activity while additions are the result of IPOs.

The spreadsheet continues to make use of Microsoft's MSN Money automatic Stock price download toolbar within Excel to get current stock prices for each company. To update the prices you need to update the prices on sheets “Raw 1” and “Raw 2” separately as MSFT has a limit on the number of quotes you can request at one time. Right now you can only get basic market information via this service. Hopefully in the future you will be able to get some financial statement information.

Download software_universe_1104.xls

Frank Quattrone Is Either Innocent Or The Most Incompetent Criminal The World Has Even Known

In what has to be one of the more troubling travesties of modern American justice, Frank Quattrone, the former head of Credit Suisse First Boston’s (CSFB) Technology Group was convicted of obstructing justice yesterday.

A Single E-Mail
The sole piece of substantive evidence in the trial was a single e-mail. Ninety-eight percent of the e-mail was actually written by somebody else who had already sent it out to the entire Technology Group in a separate message. When Frank received the e-mail himself, he decided to hit “Reply All” and add 22 words which encouraged everyone in the group to pay attention to the first e-mail.

As a former research analyst in Technology Group, I can speak with some authority when I tell you that Frank often added such “color commentary” to e-mails as a way of reinforcing messages to the group or adding his own quick take on a matter. I can also tell you that Frank was constantly swamped in a sea of e-mail and voice-mail and seemed to need every free second he had to keep from falling permanently behind in his communications. For example, I remember taking a 45 minute taxi ride with Frank to the airport in Paris and I think he must have answered 100 e-mails and 20 voice mails in that time and still didn’t get through his backlog.

Not surprisingly, in addition to this one e-mail, there were literally hundreds of other e-mails, phone calls, and voice mails that Frank processed the same day that he sent the e-mail in question. What is surprising, is that the government decided to build an entire obstruction of justice case on this single e-mail.

The e-mail in question had to do with CSFB’s “document retention” policy. The e-mail encouraged everyone in the technology group to “clean up” their files in accordance with the policy, which in other words means destroy any files you have that you don’t need right now. Now as everyone in business knows, “document retention” policies are simply excuses for firms to destroy documents that might come back to haunt them if they were ever subpoenaed in a civil or criminal lawsuit. Despite their seemingly nefarious purpose though, these policies are not only legal, but they have been adopted and are religiously followed by just about every major company in the world.

Given this, the e-mail in question probably wouldn’t have been notable except for the fact that the government had recently launched an investigation into how investment banks, including CSFB, had allocated shares of Initial Public Offerings (IPOs). Further complicating matters was that Frank himself had been told of this investigation by CSFB’s head lawyer before he sent his own, now infamous, e-mail.

Putting two and two together, the government maintained that Frank was worried about the investigation and thus decided to send his 22 word e-mail with the intent of making doubly sure that everyone in the group destroyed any documents that might incriminate CSFB or the Technology Group. In short, Frank had criminally tried to obstruct justice.

At first blush, this line of reasoning doesn’t seem that far out. After all, Frank did know about the investigation and he would likely have a lot to lose if the government leveled a major fine against CSFB or charged it with a crime. What better way to ensure that the government probe went no-where than destroying any documents that might bolster the investigation? From the government’s perspective, it’s as if Frank sat down behind his computer and with criminal glee rubbed his hands together as he began to compose the 22 word e-mail that would foil the government’s investigation once and for all.

The World’s Most Incompetent Criminal
While such visions might make for good theater, and undoubtedly can sway the minds of impressionable jurors raised on the caricatured conspiracies that populate prime time television, they fall flat on their face when one subjects them to even the slightest tests of logic and reason and gives Frank even a modicum of intellectual credit.

This failure can be best illustrated by a simple series of questions:

1. What moron would send an e-mail to hundreds of people publicly encouraging them to obstruct justice? Frank was well aware that his e-mail was recorded (as he had mentioned in previous e-mails). He was also well aware that e-mails can be forwarded over the internet to anyone on the planet, including anyone at the SEC or the US Attorney’s office. Given this, why in the world would he make a public e-mail the centerpiece of his criminal conspiracy to obstruct justice? That would be like a bank robber taking out an ad in the paper to tell his accomplices about the location of their next heist. Why send an incriminating e-mail when he could have just walked out of his office and quietly ask one of his trusted lieutenants to get the job done? It just doesn’t make sense.

2. Why in the world would Frank “pile on” the original message? The actual “clean up your files” e-mail was drafted and sent by another person within the technology group who admitted he had no knowledge of the pending investigation and was not charged by the government. If Frank was truly intent on obstructing justice, this guy presented Frank with the perfect corporate finesse play. All he had to do was just step back and let this guy do his thing and the deed would be done with “plausible deniability” in place for everyone. Instead, Frank inexplicably decides to clearly implicate himself by amending 22 largely superfluous words to the original message and sending it out for all the world to see.

3. What kind of conspiracy to obstruct justice relies on 22 words in an e-mail to get the job done? I am a believer in the power of e-mail as much as the next guy, but it strikes me that if one were truly intent on obstructing justice, I can’t imagine that they’d entrust the success of their entire endeavor to a 22 word e-mail reply. Where are co-conspirators, the additional e-mails, phone calls or voice mails? Where’s the “deep throat” who reveals the secret emergency meetings between Frank and his top aides where they plot their strategy for foiling the government’s investigation? Where’s the secretary that tells of Frank's frantic requests to erase his e-mails and change his phone logs? If Frank truly felt that his livelihood and reputation were on the line and he therefore needed to obstruct justice, he appears to have made quite a half-assed effort at getting the job done.

The fact is, if you ask yourself these questions and you still believe that Frank Quattrone is guilty of anything more than poor timing and forgetfulness, then you must also logically conclude that Frank is one of the most incompetent criminals the world has ever known. In fact not only is he incompetent, but he’s also wildly inept at corporate politics and so lazy that all he bothers to do for his grand conspiracy is send a 22 word e-mail.

The Real Frank
The reality to anyone who knows Frank and has spent time with him is that he is anything but incompetent, inept and lazy. In fact, my guess is that if you polled all the people who have seriously interacted with him, I suspect that about 95% of them will say that Frank is one of the most competent; accomplished, and hard working people they have ever run across.

In light of Frank’s prodigious intellect and effort, the government’s case boils down to trying to make you simultaneously believe in two impossible contrasts of the same man: one the one hand, Frank is the wildly successful, Wharton-educated, Wall Street power broker at the top of his game, while on the other he is the complete idiot who risked his entire position in life on a blatantly incriminating e-mail that he didn’t need to even send in the first place.

The Real Crime
The ultimate irony of all these histrionics is that the government’s much touted IPO investigation was a complete flameout. No indictments, no trial, no pleas, no nothing. Left at the precipice with nothing to show for countless hours of work and millions of dollars of tax payer’s money, the government no doubt felt strong pressure to show something for all its efforts. So strong in fact, that they went ahead with a case that has just one substantive piece of physical evidence as its centerpiece.

It is hard to imagine that the federal prosecutors of this case, all of whom are no doubt highly distinguished and intelligent in their own rights, seriously believed in their own contorted and illogical caricature of Frank. Perhaps they saw Frank’s prosecution as necessary to justify their original investigation or perhaps they felt that Frank had committed real crimes that their original investigation could not prove and thus they were serving justice albeit in an indirect way.

Whatever the case may be, Frank’s conviction marks a sad chapter in our legal history for it shows that logic and reason are no match against innuendo and invective when the government decides that it wants to create a case. By the dictates of common sense and circumstance Frank Quattrone is an innocent man, but these days it seems as though neither the government nor the media wants to let common sense get in the way of a good story and that is the real crime.