Software Stock Update: 10/04

Software stocks had a strong October with the average stock up 6.7% and the Software Index up 5.6% overall compared to the NASDAQ market’s 4.1% gain in October. You can find a spreadsheet that details these figures here. Apparently investors liked what they saw in what are traditionally weak Q3 reports. This should set up software stocks to close the year strongly given that Q4 is traditionally the strongest operating quarter for the software industry.

In terms of my hand picked virtual software stock portfolio, the portfolio had a decent month with the average stock up 4.3%. This outperformed NASDAQ slightly, but lagged the Software index. On an overall basis, the portfolio is now up 18.4% since January vs. an 8.3% decline on the NASDAQ, so it is outperforming the overall market by over 27%.

My main change for this month is that I am covering my Commerce One short as CMRC filed for Chapter 11 this month and was subsequently de-listed.

Details on the specific stocks in the portfolio:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: This is a turn around story in the hot business intelligence space. The story took a hit this quarter though when the company missed top line estimates and didn’t inspire confidence about Q4.
Performance: Since 1/26/04: -29.7%, Sept vs Oct: -29.9%
Comments: Blew their Q3 report and the stock got properly hammered 30%. Turn around might take longer than I expected with the stock basically at a “dead money” floor right now of around 1X revenues.

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: -30.2%, Sept vs Oct: 8.3%
Comments: Up nicely this month in very tentative trading. Reports on 11/1. This is the report that will either confirm that the merger is working or raise some questions.

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: -5.0% Sept vs Oct: 1.4%
Comments: Pre-announced a Q3 top line miss, but the stock was basically flat thanks to its already low valuation. We will see how it responds to the detailed earnings release. Stock still is very jumpy on light volumes.

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: -15.9% Sept vs Oct: -6.9%
Comments: Reported a decent quarter with 1st GAAP profit in awhile, but the street didn’t like the go forward guidance. Everything else looked good in the quarter though, especially top line growth. Still like the content management space overall and I think Stellent is doing a much better job at executing, so I am going to hang on to this one.

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.
Performance: Since 6/30/04: +109.2% Sept vs Oct: +31.1%
Comments: Best performing long pick four months in a row now. Volume is really picking up in this stock which suggests that it is being “discovered” by Internet investors. At ~15X 2005 EPS the stock is no longer dirt cheap, but it’s still pretty attractive thanks to strong business momentum. I don’t see why it couldn’t double again from here by middle of next year.

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: +41.3% Sept vs Oct: 6.9%
Comments: AUTN traded off a bit this month on a lackluster earnings report as investors realize that the growth required to sustain its premium valuation will be hard to come by.

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: +97.1% Sept vs Oct: +63.9%
Comments: CMRC filed for Chapter 11 in October and was promptly delisted by the NASDAQ. I am covering the short at CMRC’s final NASDAQ close of $0.05. In many ways, this was the perfect short. A bitter sweet story all in all, but one that you could see coming a mile away.

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: -9.9% Sept vs Oct: -6.0%
Comments: RSAS did not miss their Q3 report and the stock traded OK as a result. Apparently investors believe that a deal with AOL for retail tokens will be a big boost. I suspect the only thing the AOL deal will do is cause corporate investors to ask why they are paying so much more for their own tokens. As a generic short I like the stock because it seems to track the market well in the absence of any real news which is good for the overall 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: -56.2% Sept vs Oct: -30.0%
Comments: Yikes this short is killing me. CRM is now trading at 12X enterprise value to sales and almost 16X tangible book. All this despite increasing competition from big boys like Seibel and Oracle. The fundamental investor in me is screaming at me to hang tough while the momentum investor in me is begging my to cut my losses and run. Company reports Q3 numbers in mid-November (doesn’t anyone wonder why it takes 1.5 months to close the books on a subscription based ASP?), so I guess I will hold on this month. I worry that the retail investors in this stock will buy more when the company increases its 2005 guidance by a penny or two off its laughably low $0.15.

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: 3.3% NA Sept vs Oct: 3.3% NA
Comments: Stock traded down slightly during the month despite a wildly uninspiring Q3 report of $44K in revenues and around $4M in cash burn. Company still has $5M in cash left thanks to a $3M private placement during the quarter (lord knows what the private placement investors are thinking), but they will need more where that came from by the end of Q4 at this rate. They made a big deal about $343K in contracts during the quarter. It’s going to take a lot more than that to keep this ship off the shoals.