Burnham's Beat

Application Management Merger Mania

The game of musical chairs in the application management space just got a bit harder today as IBM announced that it had acquired one of the leading players in the space, Cyanea. The Cyanea acquisition is just the latest deal in the space which has seen Veritas buy Precise , Mercury buy Performant , and ASF buy Dirig. Only two independent companies of note are now left in the space, Wily and Altaworks.

Houston, We Have An Application Problem
Why all the interest in application management? Because, as many companies have unpleasantly discovered, getting distributed component-based applications to work correctly is a major pain in the neck. Unlike traditional mainframe applications, distributed applications are composed of many small pieces of software. What’s more, these pieces of software are often distributed across several servers. Throw in some web services and you can have an “application” that spans multiple computers in multiple locations. This may sound cool, but when something goes wrong in such complex system even if you are a rocket scientist it’s almost impossible to figure out what code is actually “broken”.

By monitoring the inner-workings of applications, often down the method and thread level, application management programs attempt to not only figure out what, if anything is broken in a distributed application, but they also attempt to identify resource and performance problems before they end up taking an application down.

The Great Debate: Horizontal vs. Vertical
One major problem for application management software is that there are a lot of factors that can affect application performance outside of the application code itself. Even if the code is perfect, problems with other parts of the technology stack such as database resources, network performance, message brokers, etc. can still seriously affect application performance.

Given the inter-dependence of all these items, the holy grail of application management (and for that matter systems management in general) has always been to build a holistic map of all the hardware, software, and network resources associated with a particular application and to, somehow, build a management solution that can identify the actual root cause of any particular problem no matter where it lies in the stack.

Unfortunately, like most IT holy grails such as universal object libraries, consistent semantics, and stable Windows machines, the vision of a completely unified application management stack is a long way from reality.

In the interim, vendors have generally decided to focus on either horizontal or vertical management strategies. Horizontal strategies stress the importance of following a transaction “in-flight” as it flows throughout its life-cycle, no matter what platforms it may decide to travel on. To support this strategy, vendors must make their software compatible with as many application servers as possible including modern ones (such as J2EE and .NET) and legacy ones (CICS and IMS). The horizontal view is particularly important inside large companies with complex legacy systems as most of their new distributed applications must still interact regularly with legacy platforms.

Other vendors a pursuing a vertical strategy of trying to link together information from the database, network, and application layers in order to derive a view of all of the technology components that affect a particular application. This strategy is better suited to “self-contained” applications that don’t interact with legacy platforms.

The reality is that for most Global 2000 corporations, horizontal solutions are much more practical given the topographical and political realities in those organizations. Most of those companies still have lots of legacy applications and they generally have very complex IT infrastructures. This means that distributed applications not only have to play nice with other platforms, but managerial and budgetary control over IT resources is often widely dispersed throughout the organization. While it might be nice in theory to instrument all of the databases in a company with a particular application management platform, just try telling the database administrators that they are going to be forced to use the same tool as the application managers. In general, that’s just not going to happen.

Sayonara Cyanea
As it happens, Cyanea was pursuing a horizontal strategy. It had a unique “probe/repository” architecture that makes it easily extensible to multiple platforms and it was the first player in the space to support IBM’s venerable CICS and IMS mainframe “app servers”. Given this, plus IBM’s early investment and reseller relationship it’s really not surprising that IBM decided to bite the bullet and buy the rest of the company it didn’t already own.

For me personally, the acquisition wasn’t surprising because I was actually the first investor in Cyanea and had seen the IBM relationship grow in size and importance first hand. While it’s a bit bittersweet to seen one of my promising investments swallowed up by Big Blue just as it is hitting its stride, I must admit that the ample return on investment provides me with more than a little comfort.

Wither Wily?
One of the big remaining questions following the Cyanea deal is what will become of Wily. Wily was the pioneer in the space and has always been the largest player (though Cyanea was rapidly catching up to them). It’s rumored that Wily turned down a $100M buy-out offer from Mercury in early 2003 before Mercury bought Performant for $22.5M (that may just be some good underground marketing on Wily’s part though).

On the one hand, Cyanea’s sale looks like good news for Wily. Not only does it leave Wily as the only substantive independent player in the space, but it removes a competitor that was increasingly beating it in competitive bake-offs.

On the other hand, with IBM buying Cyanea and integrating it more closely into its product lines, Wily will now face all-out competition from IBM, a platform that supposedly accounts for a majority of their sales. In addition, Veritas recently signed a wide ranging partnership with BEA making Precise the recommended application management solution for WebLogic. Thus with Cyanea at IBM and Precise at BEA, Wily faces the unappetizing prospect of having to face “in-house” competition for every WebSphere and WebLogic sale. In addition, Wily’s core product architecture, which relies on code “wrapping” to instrument it, is dated and not readily extensible outside of J2EE environments.

Despite this, some have suggested an IPO is imminent, but that does not seem likely until Wily figures out a growth story beyond J2EE. Fortunately, on the M&A front there are a few large players that have yet to make a major move in the space, most notably HP, Oracle, SAP, and Sun, so Wily may yet have an opportunity to make it to the alter on time. Whatever Wily decides to do they will have to do it quickly as they are now going from a situation of being top dog to underdog against some of the strongest software sales forces in the business, which is not an appealing prospect not matter how you look at it.

Many Miles Still To Travel
For the application management space in general, the consolidation of the independent players into the major platform players, represents a logical and necessary industry evolution. While the industry is still a ways away from the holy grail of unified management it is making steady progress. Attention will now likely shift towards integrating a few other pieces of disparate infrastructure software, such as business activity management, dependency mapping tools and cluster management tools into the overall application management framework. While each step will take the industry closer to management nirvana, new technologies and corresponding challenges will undoubtedly emerge and thus push the goal further out into the future.

Internet Stock Excel Spreadsheet

Attached is an Excel spreadsheet of Internet-focused public company stocks that is updated as of 12/31/04. I use this spreadsheet to help spot potential long/short ideas in the Internet sector. There are two other worksheets in this workbook. One sheet tracks overall industry performance, basically an index of Internet related stocks, while the second sheets tracks additions and subtractions to the universe.

In terms of recent performance, Internet stocks another great month with the average stock up a whopping 18% and the overall index up 8.4% compared to the NASDAQ's 6.2% increase.

I spend most of my time looking at software related investment ideas so I haven’t added a lot of extra analysis to this spreadsheet.

The spreadsheet makes 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 just hit a button. 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 internet_universe_123104.xls

DIM: Hijacking IM for Data Transport

Move over teenagers, the heaviest users of instant messaging are about to become computers themselves. In the beginning, IM communication was strictly a human-to-human affair. A few years ago companies starting sending alerts (and increasingly spam) via IM making it a computer-to-human affair. Now, with the advent of Data over Instant Messaging (DIM) technology, IM is rapidly set to become a computer-to-computer affair.

Why send data over IM? One reason is that IM infrastructures have solved a lot of tough technical problems such as firewall traversal, multi-protocol transformation, and real-time presence management. Sending messages over these networks allows applications to leverage the investments made to solve these tough problems. Another reason is that many companies already have IM “friendly” infrastructures which means that all the necessary firewall ports are open, the clients are already certified and installed, and operations infrastructure like logging, back-up, and even high-availability are already in place. Thus by using IM for computer-to-computer communication, developers are able to “hijack” all the valuable investment made in IM and use it for a purpose that its creators likely never intended.

Of course, DIM-based communications have many of the same drawbacks that human-to-human IM has. Because IM is a real-time “fire and forget” system, DIM lacks many of the hard-core transaction capabilities that most Enterprise Application Integration (EAI) solutions incorporate. Thus you wouldn’t want to rely on DIM for mission critical transactions management. In fact, a full blown EAI system with a rich work flow capability, rules-based message management and semantic mapping capabilities is more capable and reliable than DIM for just about everything.

However, a full blown EAI system will also cost you millions and take at least 6 months to get up and running. With DIM, the infrastructure is already in place, so not only is the time to deploy radically accelerated, but the overall cost of the installation is also dramatically lower. In addition, because DIM is a relatively simple, lightweight technology it is comparatively easy to integrate into applications, especially desktop applications. DIM is just one of the low-end EAI technologies I have written about in the past that threaten to give the traditional “high-end” EAI vendors a run for their money.

To see a good example of DIM in action you need to look no further Castbridge’s Data Messenger product. Castbridge just released the 2.0 Beta of their product and it is chock-full of DIM goodies. The Castbridge product essentially allows other applications to instant message each other both inside and outside the firewall. Most customers use the technology to link desktop applications together (such as linking two Excel spreadsheets over the Internet) but the platform itself can be integrated into just about any application or database out there.

Castbridge’s customers are putting the technology to use in some very innovative ways. For example, the Singapore Police Department is using Castbridge’s DIM technology as a way to quickly and easily share security information during major events (trade shows, parades, etc.). In the past, each agency had its own systems for collecting and reporting information on any activity (e.g. “Man arrested for chewing gum at entrance”) during a major event. While each agency had a representative in the overall command center, the only way to share information was by yelling across the room to a colleague. With Castbridge, each agency simply enters their data into a standard Excel spreadsheet. The Castbridge technology sends instant messages to all the other spreadsheets as soon as new data is entered effectively keeping everyone instantly up-to-date on the current security status and dramatically reducing the possibility for miscommunication. This problem is not unique. In fact, some F-16s almost shot down the Gov. of Kentucky’s plane over Washington DC recently because the FAA controllers had no easy way of notifying the Homeland Security Department and NORAD about that plane, so it sounds like the US government could use Castbridge’s solution as well.

There are a myriad of other uses for DIM-like technology for everything from keeping sales forecasts up-to-date, to keeping inventory and financial information current. On Wall Street, where spreadsheets abound and real-time communication is paramount, use cases for this technology are rampant. Syndicate desks could create real-time distributed order books, while fixed income desks could give clients “live” lists of inventory and derivative traders could ensure that their pricing models instantaneously incorporate the latest data.

The strong potential for DIM on Wall Street is probably why one of the biggest vendors of traditional IM technology to Wall Street firms, IM Logic, recently announced it’s own DIM product called IM Linkage which is designed explicitly to help Wall Street firms leverage DIM.

As DIM starts to see wider adoption it will be interesting to see how the major IM networks respond. On the one hand they probably won’t take kindly to the idea of computers “hijacking” their networks to send data around the world (hard to monetize that kind of traffic) but on the other hand they may seem DIM as a new revenue source where they can possibly take a cut of license sales in return for certifying DIM-apps on their networks.

However things evolve, you can be sure of one thing: DIM-based applications are here to stay and their impact will be felt by everyone from traditional EAI vendors to application owners, to IM networks. Let the data messaging games begin!

How to Hide A VC Write-down

A good VC knows that nothing ruins a fundraising pitch like taking a big write-down on an existing investment in the middle of raising money. So it’s no surprise then that with a large number of VC firms back in the fundraising market for the 1st time since 1999/2000 write-down “avoidance” has become a hot, if somewhat forbidden, industry topic.

Valuing a VC portfolio has always been a little bit of a black art thanks to the fact that most VC investments lack any kind of objective valuation measure other than the price per share of the last round of financing. This situation is complicated by the fact that most companies only sell stock once every 2-3 years providing precious few opportunities to truly “mark to market” a particular investment.

The result of such infrequent pricings is that the valuations of existing VC investments tend to lag the public market by 18-24 months. This lag is why most VC’s had dismal performance in late 2001 through early 2003 even though the worst of the public market’s decline had already occurred.

The Last Temptation
With no public market to enforce daily valuation discipline, VCs can sometimes be tempted to “manage” their portfolio valuations, usually by neglecting to cast a critical eye on valuations that have become permanently impaired or by supporting “inside” rounds of new financing at unrealistically high valuations.

While many VCs initially attempted such portfolio “management” in the early stages of the Internet bubble’s collapse, by the middle of 2002 most had capitulated to the market and began to mark down their most egregiously overvalued investments. Some farsighted firms took a particularly aggressive “kitchen sink” approach in which they undertook wholesale write-downs across their entire portfolio in an effort to reset LP expectations to a valuation baseline from which there theoretically could only be good news (surprisingly, some limited partners opposed aggressive write-downs because they hurt their own performance/compensation).

While no VC likes to take write-downs, two important factors made the period of 2001-2003 relatively write-down “friendly”. These factors were A) the fact that everyone else in the VC business was taking big write-downs and therefore relative performance was not suffering dramatically (indeed it’s still possible to be a “top quartile” Vintage 1999 fund and have a negative IRR) and B) Few firms needed to raise money during that period (the VC industry actually had net negative fundraising in 2002) so the write-downs did not threaten to disrupt the marketing of anyone’s next fund.

What A Difference A Year Makes
As we enter the second half of 2004, the two factors that made 2001-2003 relatively write-down “friendly” have largely evaporated. With many firms having already taken their lumps, the overall performance of VC funds has stabilized and in some cases is improving. In addition, with many firms approaching the new commitment time limit on their 1999 and 2000 funds, a large number of established firms are now back “in the market” looking to raise new funds.

Added into this mix is the fact that many funds, even the ones that didn’t really clear the decks, claim to have put the write-downs of 2001-2003 behind them, making any new write-downs of existing investments particularly glaring. With the write-down stakes thus raised, the temptations to revert to portfolio “management” tactics are particularly rich.

The Tricks of the Trade
While creativity and invention is often the order of the day when it comes to hiding a write-down, there are several tell tale signs that should generally raise suspicion levels. These tricks of the trade include:

Insider Rounds: The easiest, but most blatant way of hiding a write-down is to conspire with fellow co-investors to do an inside round at an artificially high valuation. The argument for such behavior is actually quite compelling when all of the existing investors are participating pro-rata and already own a significant chunk of the company. In such cases, the relative ownership percentages really don’t change much no matter what valuation is used for the follow-on round and thus the only real impact of a down round is that it forces all the VCs to take a write-down. It doesn’t take much peer pressure on the average VC funded board to get everyone to go along with the plan and the common investors are usually in favor of it because they are technically getting less dilution. One of the giveaways that insider rounds are priced artificially high is that while the price per share remains the same, the liquidation preferences are increased dramatically. While insider rounds are easy to accomplish, the problem with them is that most LPs are hip to the fact that insider rounds are a warning sign, especially in the relatively active mid/late stage financing market that exists today, and thus are likely to ask some uncomfortably probing questions.

Debt Financing: Venture debt financing was basically non-existent in 2001-2003, but the market has recently come back with a vengeance. Thanks to plethora of new venture debt funds as well a number of new finance company players and (the latest craze) public investment companies, there’s a lot of debt out there getting deployed at terms relatively favorable to completely uncreditworthy start-ups. The fundamental investment thesis of the debt companies is that the VCs have too much money/face invested in a deal to let it go under just because of a few million in debt, so they are really lending against VC’s vanity/unwillingness to take write-downs more than anything else. For those lucky companies that have at some business traction but lots of “legacy” cap table issues, the VCs can get the best of all possible worlds. They get to extend a company’s runway without taking additional dilution and without taking a write-down. Of course the bill will come due in a couple years, but the next fund will be raised by then.

Convertible Bridge Notes: For those companies who are not worthy of venture debt and who are unable to convince even their own investors to invest additional equity, there’s always a convertible bridge note. VCs used to issue convertible bridge notes only in the brief period between signing a term sheet and closing a round. Those standards got heavily relaxed in the post bubble crash as many VC’s used “drip feed” convertible bridge notes as life support for ailing companies. The survival rate for these bridges was dismal and that appeared to have killed off convertible bridges for awhile, but recently they have been popping up again. From a write-down perspective, convertible bridges are highly risky because they have a huge mortality rate, but if a VC can extend the runway of firm just 6-9 months it might be enough to get their new fund closed without having to explain yet another write-down.

Do Nothing: The final way to avoid a write-down is to simply do nothing when you could do something. For example, let’s say a VC firm knows that one of its investments is headed no-where fast and should probably be sold off to one of its competitors. Normally this kind of strategic level “deal management” is why VCs get paid the big bucks. However, when such deal management will result in a major write-down that could hurt fundraising efforts, it’s often hard for a VC to get excited about doing the right thing. These are the most difficult “hidden” write-downs to spot because there’s no obvious paper trail to follow. These can only be discovered by hard core, deal specific diligence, the kind of diligence that few LPs have the time to do.

You Can Fool Some People Some of the Time…
Of course no matter what machinations VCs come up to hide a write-down, “truth will out” as they say and eventually the true market value of company will come to light when it either dies or achieves some kind of liquidity event.

Even without some kind of external event, the best limited partners can still ferret out overvalued portfolio deals by asking the right set of questions, doing some basic diligence, and comparing notes. Some LPs have even discovered “hidden” write-downs by simply comparing the carrying values of the same investment held in two different funds.

However they find them, venture LPs had better shine up their magnifying glasses and put on their gum shoes because in this environment hiding write-downs is so tempting that it may be impossible for some VCs to resist.

Software Stocks: Mid-Year Update

Software stocks have been flat since the beginning of May with the average stock price changing a grand total of 0.0% over last two months. From a market cap perspective, the aggregate market cap of software stocks was up a seemingly robust 3.4% but almost all of this gain was due to MSFT (which comprises about 38% of the total software market cap). Excluding MSFT, software market cap was down slightly, 0.5%, in the last two months.

In terms of my hand picked virtual software stock portfolio, the last two months have seen decent performance with the overall portfolio up an average of 8.6% vs. the software sector’s 3.4% and the NASDAQ’s 3.3%. The portfolio continues to be way too long so I concentrated on adding some short picks this month to try and increase the short exposure. It’s not that I am particularly bearish (I am actually feeling kind of “flatish”), but I am way too long in general with 4 long picks and 2 short picks.

Overall since it’s inception on 1/26/04, my software stock portfolio is up 14%, a nice increase from 4/30’s 8%, and almost 19% better than the NASDAQ market’s 4.9% decline during that same time period.

Details on the specific stocks in the portfolio:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: I continue to like Actuate as a relatively cheap name in the white hot business intelligence space. I should have paired this trade with a short of BOBJ (the richest name in the group) but I missed that one. At 1.9X enterprise value/sales ACTU has lost much of its discount to the rest of the group which still trades at 2X but I like the fact that it is about to break back into EPS positive territory which usually provides a nice bump.
Performance: Since 1/26/04: +12%, Apr vs. Jun: +21%
Comments: Stock got a nice boost when Barron’s cited it in an article as a relatively cheap BI play. Hey maybe someone from Barron’s is reading this blog … nah I doubt it.

Company: Blue Martini Ticker: BLUE
Sub-sector: Vertical Solutions
Investment Thesis: A stock in transition from a middleware play to a vertical app play. I made money with a similar trade on ARTG in 2001. The stock is cheap at 1.6X tangible book and only 0.4X ev/sales still these transitions can be rocky. The thesis is that they will succeed in breaking even by the end of the year which will result in a recovery to the 1X ev/sales range.
Performance: Since 1/26/04: -11%, Apr vs. Jun: -5.5%
Comments: In my last update, I mentioned that this is the stock I have the least conviction about from a fundamental business prospects perspective. Just as I was writing this update, the news came out that they are going to miss their quarter and the stock dropped another 20% or so. I will have to seriously consider taking this stock out of the portfolio at the end of July unless there is some serious silver lining when they report.

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 as 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 overall valuation as they cement their leadership position in the e-learning space.
Performance: Since 1/26/04: -15%, Apr vs. Jun: -3%
Comments: After a bad 1st month after the merger, the stock has basically stabilized over the past two months. This quarter’s report will be critical. If they have succeeded in making the expense reductions while holding the line on revenue, then the company should be on a clear path to profitability which should help the stock. My guess is that the report will still be a bit messy and this stock will have to wait until Q3/Q4 to shine.

Company: SPSS Ticker: SPSSE
Sub-sector: Business Intelligence
Investment Thesis: 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 1.2X 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: 26% Apr vs. Jun: 26%
Comments: I added this stock to the portfolio on 4/30 and it’s performed very nicely since then. It’s my favorite name in the BI space (much better than ACTU). Still trades at a very healthy discount to the BI space’s 2X ev/sales. Accounting issues are still a concern, but they should be able to get their act together. It should go up another 50% as soon as the delisting and accounting issues clear up.

Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, file management company that is attractively priced. Last quarter was the first quarter of positive cash flow in awhile and this quarter should see some positive EPS for the first time in awhile. With $75M/quarter in revenues, Stellent has a lot of room to work on expenses and should be able to return the company to solid profitability at which point the stock should recover from its current 0.5X ev/sales to something much closer to 1X.
Performance: Since 6/30/04: NA Apr vs. Jun: NA
Comments: I am worried about adding STEL because it has been a great performer over the last two month (up 25%+), but I think there’s more to come as the market gives the company credit for becoming profitable again.

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Internet Payments
Investment Thesis: Every portfolio needs a flyer 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 online gambling, that PayPal has been pressured into existing by the US Justice Department. I know, I know, this is not a software stock, but I still follow online financial services quite closely and I feel compelled to point out this stock because it is such an attractive buy. After going public in London on 4/14, the stock is now trading at just 10X 2004 EPS and yet is growing like an absolute weed. Neteller has got to be the best and only Internet “value” stock out there. Sure the stock trades at a steep discount due to the regulatory ambiguities of online gambling, but the feds can’t lay a finger on these guys as they operate entirely outside of the US.
Performance: Since 6/30/04: NA Apr vs. Jun: NA
Comments: With a small float and lots of regulatory issues, this stock is likely to be a wild ride, but the numbers are flat out impressive. This company is a compelling purchase for a European or Asian Internet portal.

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 trades at a huge premium to the market at 6.3X 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 remain compelling.
Performance: Since 1/26/04: +15% Apr vs. Jun: -8%
Comments: Stock hit a floor at about $20/share and has bounced back a bit. The valuation still perplexes at these levels. That said, the stock still appears to have a strong core of believers who are buying on weakness. I don’t think there’s a lot of stock specific downside in the stock right now, but it’s a good marketl short, so I will keep it in place.

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. CMRC 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: +57% Apr vs. Jun: +20%
Comments: CMRC remains the best performing pick in the portfolio. After Q1’s dismal report, it’s hard to imagine that Q2 will be much better. With the preferred/debt overhang this still has a great chance of being a complete zero shot.

Company: Redhat Software Ticker: RHAT
Sub-sector: Operating Systems
Investment Thesis: I need short exposure and what could be a better short than one of the highest valued stocks in the entire software sector. Redhat is the Linux poster child and has the largest independent distribution of open source Linux-OS. As the poster child for all things Open-Source Redhat has been the recipient of tremendous investor interest and its valuation reflects it. At 22X ev/sales and 13X tangible book, investors are apparently expecting RedHat to take over the world. This despite the fact that Redhat sells just one of several Linux distributions and faces competition from IBM, NOVL, and possible folks like SUNW and HP. I have heard an increasing number of people complain about RHAT’s pricing schemes and it remains an open question as to whether any Linux distributor will have any kind of pricing power. Shorting the market leader against a trend as powerful as Linux is not to be done lightly, so I won’t defend this short against all foes, but it does seem like it could definitely cool off a bit more.
Performance: Since 1/26/04: NA Apr vs. Jun: NA
Comments: RHAT was seemingly unstoppable until a top-line miss in its last earning report gave everyone a big taste of reality. With such a high multiple, it’s a great short complement to my low multiple longs and with the recent miss, even if the stock does perform investors will be careful not to let it run too far.

Company: Concur Ticker: CNQR
Sub-sector: Vertical Applications
Investment Thesis: Concur is a nifty little ASP that let’s companies do time and expense management. I used Concur when I was at Mobius and it’s a very good application. The only real issue I have with Concur is valuation. Concur trades at 18X tangible book, over 6X ev/sales, and 100X 2004e EPS. Now if Concur were on the front end of potentially world changing trend in software (like RedHat) I might not find this to be too expensive, but Concur is niche application focused on corporate expense management. It also happens to face competition from all the big ERP players who all have this capability on their “to do” list at some point in the future. Perhaps Concur is benefiting from the Salesforce.com “halo” or perhaps everyone thinks Salesforce.com will buy them (they do seem like a good fit), but at this valuation just about everything is going to have to go right for right them.
Performance: Since 1/26/04: NA Apr vs. Jun: NA
Comments: Unlike RHAT which has lots of fast money in it and plenty of liquidity, CNQR is a relatively sleepy stock. It will need some kind of stock specific negative catalyst to get it headed in the wrong direction which may or may not come in the next few months. All the good news seems to be in the stock, so this is more just a case of waiting for some bad news.

In April, I mentioned a bunch of stocks that weren’t in the formal portfolio, but were potential candidates. Those stocks included: Long: Interwoven (IWOV), Stellent (STEL), and Hummingbird (HUMC), E-Loyalty(ELOY) Short: Convera (CNVR). These “potentials” were up an average of 9% compared to the formal portfolio’s 6%, so shame on me for not formally adding them. I added STEL to the formal portfolio this month while I continue to watch the others.