Software Stock Update: 8-04

August was another poor month for software stocks with the average stock down 3.7% vs. a 2.6% decline for the NASDAQ in general. Small caps actually did slightly better than large caps this month, but that’s probably because small caps got killed in July and there just weren’t a lot of sellers left.

In terms of my hand picked virtual software stock portfolio, the portfolio had a great month with the average stock up 6.0% vs. the NASDAQ’s 2.6% decline and the software sector’s 3.7% decline. 7 out of the 10 stocks in the portfolio had a positive month with the short side more than making up for losses on the long side. On an overall market weighted basis, the portfolio is now up 15.2% YTD (it’s up over 17% on a cost weighted basis) vs. a 14.7% decline on the NASDAQ, so it is now outperforming the market by almost 30% despite having been strongly net long for the first 7 months of the year.

While several of my shorts seem to have performed about as well as they can in the short term, I don’t have a lot of new ideas so I will leave them in place for this month. I expect September to be more of a mixed month, as investors concentrate on adjusting their portfolios ahead of the Q3 reports (which in general should be light).

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: -11%, Jul vs. Aug: -13%
Comments: Another bad month on very weak volume. BI continues to be strong and the company continues to make product progress, so I won’t sell for now.

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: -37.3%, Jul vs. Aug: -3.6%
Comments: Didn’t have the disasterous month that it had in July and seems to have bottomed out a bit. Worst performing stock in the portfolio right now. I will give it another quarter to see if they make progress on clearing up the debris from the merger.

Company: SPSS Ticker: SPSS
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. My thesis is that the new product set is strong and the accounting trouble is overblown.
Performance: Since 4/30/04: -3.0% Jul vs. Aug: -6.8%
Comments: Had a poor earnings report in August when it missed license revenues by $2M. Stock would have been hurt more, but the NASDAQ decided to relist them to the NMS, so that helped somewhat. Still like the BI space and the relative valuation of this company. Stock is very jumpy on light volume though.

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% Jul vs. Aug: 0%
Comments: After a poor July, STEL calmed down a bit in August. Seems like it will range trade a bit here until Q3 report.

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 about 15X estimated 2004 EPS and yet is growing like an absolute weed.
Performance: Since 6/30/04: +28% Jul vs. Aug: +12.1%
Comments: Best performing long pick two months in a row now. Will announce it’s 1st half 2004 results mid-September (they move slowly over there in the UK). Stock ended the month just above its IPO price and at a 52-week high. Guess it is getting discovered now. Still a decent bargain at 15X this year’s EPS and less than 10X next year’s given its growth rates.

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 continues to trade at a premium to the market at 3.6X enterprise value to sales however its decline has brought it to a more reasonable level. 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.
Performance: Since 1/26/04: +46.1% Jul vs. Aug: 1.9%
Comments: Seems to have bottomed out a bit after last month’s 36% drop. Still don’t like the space, but I am worried that the downside might be limited from here on, but the stock continues to have a premium valuation and its Q3 should be weak as it gets the majority of its sales from Europe.

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: +72.2% Jul vs. Aug: +20.5%
Comments: CMRC remains the overall top performer in the portfolio for the 5th month in a row. The Q2 earnings report was not encouraging with just $350K in license revenues and cash burn of $4.8M. That’s a lot considering that the company had a grand total of $4.3M in cash at the end of Q2 and $4M of short term debt. With a current ratio of 0.84 the only way this puppy survives is with a massive (read $10-$15M) equity infusion which would have to come on top of the $12.5M in existing preferred. In-lieu of a financing, it’s Chapter City for CMRC. Either way the common holders are looking at a zero shot. Needless to say, this pick remains firmly in the portfolio.

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 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. From what I hear Redhat’s move into the App Server business went over like a lead brick at Big Blue. That combined with continued customer grousing over price changes has made RHAT vulnerable.
Performance: Since 7/1/04: +46.5% Jul vs. Aug: +28.4%
Comments: Another terrible month for RHAT. No real news moving the stock other than folks digesting last month’s accounting restatements. Stock has almost been cut in half in just two months. The company has an earnings report this month and I gotta believe they’ll do everything in their power to put a positive spin on things so I’d be surprised if the stock didn’t trade up this month.

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 8/1/04: 20% Jul vs. Aug: 20%
Comments: RSAS had a nice debut in the portfolio as it traded down throughout the month apparently mostly on general market weakness rather than anything specific. Management has an aggressive set of investor presentations planned for September which may help the stock in the near term, but I like the fact that the stock trades well and correlates nicely with the market so it’s a good short to have in the portfolio.

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% Jul vs. Aug: 0%
Comments: I added this stock a month too late to the portfolio. CRM was down strong beginning of the month but recovered on a decent earnings report and outlook. That said, it still trades at 7.2X EV/Sales and 93X 2005 EPS (which are sandbagged). At these levels, there’s little if any room for error which gives me confidence to keep this in portfolio even though it will trade up in a positive tape.