Software Stocks: July Update

July was a flat out ugly month for software stocks thanks to a large number of pre-announcements and generally lackluster earnings guidance for the rest of the year. The average software stock was down a whopping 13.7% in July, compared to a 7.9% decline for the entire NASDAQ. However, the pain was not evenly spread around. Small Cap software stocks (stocks with market caps under $1BN) were down 12.4%, while large cap software stocks were only down 4.4% (handily outperforming the broader NASDAQ). In fact, the software index itself was only down 4.9% thanks to the relatively strong large cap performance.

In terms of my hand picked virtual software stock portfolio, the portfolio once again outperformed both the NASDAQ (down 7.9%) and the software stock index (down 4.9%), but the average stock in it was still down 1.2%. The performance is a bit better than it looks given that the portfolio had only 1 Large Cap stock (which I was short) and was still 20% net long, but it was a loss none the less. On an overall basis, the portfolio is now up 11.8% YTD vs. a 12.4% decline on the NASDAQ, so it continues to out perform the market by 20%+ despite having been strongly net long for the first 7 months of the year. Still 11.8% is down from last month's 14% net gain.

I've taken some steps this month to rebalance the portfolio towards more of a market neutral stance given that Q3 is typically weak for software stocks (although I don't know how much weaker it can get). I think I will ultimately end up net long again, but my wonderings around Silicon Valley didn't generate any compelling long ideas this month.

Details on the specific stocks in the portfolio:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: I continue to like the turn around story here and their Q2 report suggests that are making good progress at becoming solidly profitable again. It will probably take another quarter for this story to play out.
Performance: Since 1/26/04: +2%, Jun vs. Jul: -9%
Comments: Had a bad month (like most small caps), but a decent report held up the stock somewhat.

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 very cheap at 1.1X tangible book, but that's because the market doesn't have any confidence the company can successfully negotiate the transition. After looking over their Q2 earnings report, neither do I.
Performance: Since 1/26/04: -44%, Jun vs. Jul: -37%
Comments: In April I said this was the stock I had the least conviction about. At the end of June I said it was likely to come out of the portfolio and now, at the end of July, I am taking it out of the portfolio, but not after having the stock get killed with a 37% loss this month. If I day traded the portfolio I would have limited this month's losses to about 20%, but lesson learned here is that I should have pulled them out in April when I said they were at the bottom of my portfolio. I think I will do a force ranking each month from now on and kick out the stock I have the least conviction on as a matter of good management.

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: -23%, Jun vs. Jul: -35%
Comments: Stock got killed this month, most of it before they reported a decent but not spectacular quarter. Still seems well positioned to become solidly profitably in the 2nd half of this year but it is testing my patience.

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 now trades at an attractive 1.0X 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: 4.1% Jun vs. Jul: -18%
Comments: Tough month in general, but the stock had some good news at the end of the month when finally it filed its 10K and the NASDAQ indicated that it was not going to delist the company. All eyes are now on its August report. If the report is decent, the stock should really start to move in the right direction. Still feel like this is the best value in the business intelligence space by far right now.

Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, content management company that is attractively priced. Q1 was the first quarter of positive cash flow in awhile and Q2 saw pro forma, but not GAAP positive, EPS. With $20-25M/quarter in revenues, Stellent has a lot of room to work on expenses and should be able to return the company to solid GAAP profitability at which point the stock should recover from its current 1.3X ev/sales to something much closer to 2X.
Performance: Since 6/30/04: -19% Jun vs. Jul: -19%
Comments: I was worried about adding STEL at the end of June because it had such a great month (up 25%). Predictably the stock gave up most of that ground in July, but the earnings report was good enough to limit further damage. Still like the stock, but a 20% hole is not how I wanted to start!

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 exiting 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 10.5X estimated 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 hey, it's worth taking a gamble on.
Performance: Since 6/30/04: 14% Apr vs. Jun: 14%
Comments: Best long performing stock of the month. Had an interim report which showed a slight slowdown in new sign-ups/day, but still added another 125K new members in Q2 plus announced some new partnerships which should drive more sign-ups. With a little exposure in the US this stock will triple.

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: +45% Jun vs. Jul: 36%
Comments: This month's #1 gainer. A lackluster earnings report + wildly bear market = signifcant share price declines and that's just what happened to AUTN. I said I thought there was a floor at $20, looks like I was wrong. Still trades at a relatively pricey 3.8X Enterprise Value/Sales, so I will remain short during the summer doldrums which hit European companies, like AUTN, especially hard.

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: +65% Jun vs. Jul: +18%
Comments: CMRC remains, yet again, the best performing pick in the portfolio. It would have been even better, but the stock actually traded up strongly at the end of the month despite getting a delisting notice from the NASDAQ. Q2 "earnings" report should make it clear that there is no way for the common holders.

Company: Redhat Software Ticker: RHAT
Sub-sector: Operating Systems
Investment Thesis: 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, the best in the software sector, reflects it. Investors apparently are expecting RedHat to take over the world, 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.
Performance: Since 1/26/04: 25% Jun vs. Jul: 25%
Comments: RHAT announced that it had to restate its earnings due to an accounting charge and the stock promptly dropped 30%. I actually think the reaction to the announcement was way overdone as it doesn't appear to be material, but this just goes to highlight how sensitive richly valued stocks are to even the slightest bad news, which was basically the idea behind shorting it, so I feel partly vindicated by the drop. I struggled with the idea of simply covering this and moving on, but I am going to keep it in place a little bit more as it remains the most richly valued company in the space and its recent moves into the app server market may seriously piss off some of its biggest proponents and channels to date (IBM and HP).

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 16X tangible book, almost 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: 0% Jun vs. Jul: 0%
Comments: As I pointed out last month, CNQR is a sleepy stock and that sleepiness, plus a good Q2 report allowed the stock to remain flat during a terrible month for software stocks in general. While I still feel that Concur is way overvalued, the stock's performance this month suggests that it is a bad short as I need a short with much more beta to offset my long losses in a bad month. Given this I am going to cover this and move on.

Company: RSA Security Ticker: RSAS
Sub-sector: Security
Investment Thesis: I have always wanted to short RSAS. I covered the security sector when I was an analyst and basically came to hate the sector due to the fact that almost every company blows up once every 12-18 months and does so with no warning whatsoever. RSA used to be called Security Dynamics and its main product remains a "hard token" called Secure ID which they already have sold to just about everyone on the planet that is going to buy one. The stock's last major blow up was on it's Q3 report last year. I am thinking it's due for a repeat. Even if it doesn't, the stock tends to trade along with the boarder tech market and I need some shorts that more closely follow the market, so this will have to do.
Performance: Since 1/26/04: NA Jun vs. Jul: NA
Comments: Trades at 7X tangible book and 3X enterprise value/sales putting in the top quartile of software stock valuations.

Company: Salesforce.com Ticker: CRM
Sub-sector: Vertical Applications
Investment Thesis: Salesforce.com is a, mostly, hosted sales force management application. It's a good product, most of my start-up companies used it, but it is expensive the longer you use and the larger your company gets. CRM is 2nd most highly valued stock in the software space despite the fact that it is facing increased competition from the big boys of enterprise software and that its very hard to rapidly grow subscription-based revenues. Any mis-step and this stock will down 25% in a heartbeat.
Performance: Since 1/26/04: 0% Jun vs. Jul: 0%
Comments: I thought awhile about adding this stock to the portfolio last month and decided against it because I didn't see a near term negative catalyst. Whoops, I was wrong. At an analyst meeting they slightly adjusted their outlook (but just a penny or so) and the stock got clobbered. It's still very expensive though and it will be tough to please investors that have already been burned.