Software Stock Update: 9-04

Software stocks rebounded in September, essentially erasing their August losses. The total market cap of software stocks was up 3.8% this month compared to a 3.7% loss in August. The average stock was up almost 5.5% thanks to strong performances by small caps. Despite this month’s good performance, software stocks are still down almost 6% from the end of January.

In terms of my hand picked virtual software stock portfolio, the portfolio had a decent month with the average stock up 5.2%. On an overall market weighted basis, the portfolio is now up 16.5% since January (it’s up over 19% on a cost weighted basis) vs. a 11.9% decline on the NASDAQ, so it is outperforming the overall market by over 28% and software stocks by almost 22%..

Only a couple of changes to the portfolio this month: I am covering my Redhat short for now (I will be back) and replacing it with a short on Wave Systems.

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: 0.3%, Aug vs Sept: 12.8%
Comments: A good month for ACTU. Several banks on the street mentioned them as an attractively valued BI company and they appeared to “show well” at several investor presentations. Let’s hope their Q3 report keeps up the momentum.

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: -35.6%, Aug vs Sept: 2.7%
Comments: Slightly positive month. Maybe they have turned the corner. Still on probation though. Q3 report is critical.

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: -6.3% Aug vs Sept: -3%
Comments: Stock is very jumpy on light volume, but appears to be range trading. Hopefully Q3 report will eliminate profitability concerns.

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: -9.7% Aug vs Sept: 11.6%
Comments: Good month. Stock traded well through several investor conferences, so people must like what they are hearing. Lots of M&A rumors in the content management space.

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 17X estimated 2004 EPS and yet is growing like an absolute weed.
Performance: Since 6/30/04: +58.9% Aug vs Sept: +24.1%
Comments: Best performing long pick three months in a row now. Market liked its Q2 earnings report and outlook at lot. Volume has really picked up in the stock indicating that the market is really starting to take notice of the company. Tempted to take some gains here, but this company could easily trade at 30X 05 EPS, so I am going hang on for the ride.

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: +37% Aug vs Sept: -17%
Comments: AUTN had a strong month and benefited from both overall bargain hunting in software stocks and its poor float which tends to exacerbate movements.

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: +91.9% Aug vs Sept: +72.2%
Comments: I hate to say “I told you so”, but “I told you so”. Late in September, CMRC finally confirmed the obvious when they released an 8K that said they had $700K in cash left and were likely headed into bankruptcy. They are a clear Chapter 7 candidate, so I am going to ride the 0.18 that’s left all the way to $0.00.

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: +46.6% Aug vs Sept: +0.2%
Comments: RHAT was very strong the first part of the month and then traded off significantly following their earnings announcement. While they actually exceeded EPS estimates, they lightened up their revenue forecast a bit and as a result the stock got hit. This is a great example of growth expectations are all that matter for high multiple stocks. All that said, I did not like the way the stock traded this month. It should have been a big winner this month, but there appear to be a lot of star-struck Linux investors out there who are still willing to bid the stock back up. In addition, the board announced a $100M stock buyback (almost 30% of their net cash) which will put a bit of a floor on the stock. I've had a very good run the last couple months on RHAT and rather than press my luck I am going to cover this short here and lay in wait a bit.

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: -3.7% Aug vs Sept: -29.6%
Comments: Worst performer in the portfolio this month. Stock is getting good press from the street and they apparently had some good performances at a couple investor conferences. In addition, a much ballyhooed deal with AOL was announced for a retail version of their tokens, which brought in a lot of retail volume to the stock. I am going to hang on here though as the AOL deal will likely be a bust and offering a $10 retail token has the potential to make their corporate customers ask some real questions about pricing. I might have picked the wrong quarter to short this though…

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: -20.2% Aug vs Sept: -20.1%
Comments: Traded up along with the rest of the software sector, despite a couple of brokers downgrading on valuation concerns. Still think they are going to have to reset revenue growth expectations by the EOY and the valuation leaves no room for error.

Company: Wave Systems Ticker: WAVX
Sub-sector: Security
Investment Thesis: I first encountered Wave when I wrote my initial analyst report on Wall Street in the mid-1990s. Wave has remained in business largely by claiming that it is developing revolutionary security technologies, kind of like a bio-tech company that never gets out of trials. With a grand total of $1.4M in revenues over the last 3.5 years, almost $10M in cash burn during the first half of this year and only $6M in cash left, Wave finally appears to be approaching judgment day. In fact, the SEC gave them a delisting notice at the end of September. It may take until the end of the year, but I fully expect Wave to follow in the footsteps of CMRC or to wash out the existing common with a new financing.
Performance: Since 10/1/04: NA Aug vs Sept: NA
Comments: Stock traded up 15% in September, which frankly, is totally unbelievable. With only 5.5% of the float short and average daily volume of 350K there is a very shortable stock. I am simply stunned there’s not a bigger short position given the financials.