Software Stocks Update: January 2005

Software stocks started off the year with a thud with the average stock off 6% in January and the Software Stock index overall off 6% compared NASDAQ’s to 5.2% drop.  The worst performing software sectors this month were Supply Chain (-15.7%), Operating Systems (-15.4%),  CRM (-11.8%) and ERP (-11.6%).   You can get a detailed spreadsheet with all the numbers here .

In terms of my hand picked virtual software stock portfolio, the portfolio had one of its best months ever with the average stock up 9.5% and the overall portfolio up 13.8%.  This month marks the one year anniversary of the portfolio.  During that year the portfolio was up 45.5% which is not too shabby when you compare it to the 4.2% decline in the NASDAQ or the 2% decline in the Software Stock Index during that same time frame.

I am not making any changes to the portfolio this month as I want to see how all the 1st quarter reports come in which won’t be until mid-February.

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 last quarter though when the company missed top line estimates and didn’t inspire confidence about Q4.
Performance: Since 1/26/04: -28.1%, Dec vs. Jan: -0.8%
Comments: Dead money in December.  The Q1 report will determine whether or not this stock stays in the portfolio or makes a losing exit.

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: -28.3%, Dec vs. Jan: 5.0%
Comments: Potentially climbing its way out of the dog house.  Q1 report should hopefully be clean of any merger related issues and they should show a pro-forma profit.

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: 12.2% Dec vs. Jan: 2.0%
Comments: Still like the stock although the expectations for the latter half of this year are high.

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 1.5X ev/sales to something much closer to 2X.
Performance: Since 6/30/04: 0.1% Dec vs. Jan: -3.1%
Comments: Gave up some ground this month, but nothing of major concern.  Revenue growth was decent in Q4 but not great.  Company was barely GAAP profitable, but profitability should improve during the rest of the year.

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Financial Services
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: 235.5% Dec vs. Jan: 42.3%
Comments: The portfolio’s big 2004 winner started off 2005 with a bang.  This stock is “en fuego” and still only trades at 23X 2005 EPS.  I will hang on for the ride a bit more, maybe 30X, but at some point the risk/reward on this stock is going to shift the other way.

Company: Sportingbet Plc. Ticker: SBT.L
Sub-sector: Internet Gambling
Investment Thesis: Continuing my trend of UK-based non-software stocks, I feel compelled to add Sportingbet.com to the portfolio.  Sportingbet is the largest online gambling operator in the world and just last month executed an accretive deal to buy one of the largest online poker sites on the net (Paradise Poker).  At 16-17X 2005 EPS this stock is very attractive relative to its growth rate (25-30%) and especially attractive relative to other internet commerce plays.  In addition, in November the World Trade Organization ruled that it is illegal for the US to prevent US citizens from placing bets on non-US Internet sites.  While the US is appealing the ruling, it raises the possibility that US citizens will be able to legally gamble on-line which could lead to further industry growth.  I don’t like the big options overhang in this stock or the poor margins (due to sports betting business) but this is a chance to own the #1 player in an important online commerce player at an attractive valuation.  Too bad I didn’t buy it at the same time I bought Neteller as it is up about 50% since the middle of 2004.  Acquisition by one of the major US gambling concerns (once online gambling is legal), seems a distinct possibility.
Performance: Since 11/30/04: 50.9% Dec vs. Jan: 25.9%
Comments: 2nd best performing stock in January.  Q4 is traditionally its strongest quarter thanks to heavy sports betting.  It’s still not even 20X EPS, which still seems like a great deal for the #1 online gambling site on the net.

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 from some of my VC investments. 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 3.9X 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.
Performance: Since 1/26/04: +40.4%  Dec vs. Jan: -4.0%
Comments: The stock drifted up again in January thanks in part to a somewhat vague, yet positive pre-announcement.  It may make sense to consider removing this from the portfolio next 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.   Right now the street is infatuated with an AOL deal which I think has no legs.
Performance: Since 8/1/04: +5.4% Dec vs. Jan: +12.2%
Comments: Ah sweet justice.  RSAS hit its Q4 #s but guided down for the rest of year causing the stock to drop.  I will probably keep this short on a month or two more and cover given that it will start its ride back up at some point (like it always does).

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 it 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 it’s very hard to rapidly grow subscription-based revenues. Any misstep and this stock will down 25% in a heartbeat.
Performance: Since 1/26/04: -5.3% Dec vs. Jan: 19.1%
Comments: I may actually end up making money on this short.  Just a few months ago this short was killing me as it rose above $20 after getting added to the portfolio at $13.  Since then though, it has been giving ground, the latest decline thanks to tepid guidance for 2005 and increased competition from Siebel and Netsuite (which is funded by Oracle).  It still trades at over 105X 2005 EPS which I think has to look increasingly expensive in light of the heightened competition and lower forecast growth.

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 $14M in cash burn during the first nine months of this year and only $6M in cash left, Wave finally appears to be approaching judgment day. It may take a few more quarters, 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: -15.4% Nov vs Dec: 8.2%
Comments: Last month I wrote about WAVE doing a very fishy PIPE deal and I got a lot of comments from proponents of WAVX (called Wavoids), some constructive, some not so constructive.  It was actually fascinating to correspond with these folks as they passionately believe that WAVX is on the cusp of dominating the market for so-called Trusted Platform Management (TPM) software.  What struck me about these conversations was just how passionate these people were in the face of some what can only be described as an epic failure by WAVX over the past 10 years.   For a short pick, I don’t like the idea of having such a passionate following on the long side because these folks will behave irrationally and try to support the stock even when they should be heading for the hills. In addition, at around $1, it really only takes a few hundred grand to move the stock one way or the other.  That said, I am going to wait this out a bit and see what the company does to raise money again which should happen some time in late Q1 or early Q2.

Company: Convera Ticker: CNVR
Sub-sector: Content Management
Investment Thesis: I ran into Convera when I was on the board of Stratify.  I was unimpressed with Convera’s business then and I am unimpressed with it now.  They have a decent market niche in the government sector but have never been able to really expand out from there and face increasing competition from the likes of Google, Verity, and Microsoft.  The stock is up strongly in the past few months thanks to the company’s announcement that they are going to enter into the web search market.  This hype has disguised very poor license sales of the core product and a continued high burn rate (averaging about $4M-5M a quarter).   Eventually the chickens will come home to roost and investors will realize that these guys are a just a third rate enterprise search vendor.
Performance: Since 11/30/04: -1.9% Dec vs. Jan: -2.2%
Comments: Another flat month.  This stock really hinges on whether or not people buy the story of Convera getting into the web search market.  The bet is that enterprise business will stagnate before their web search product starts to take off and the stock will fall in the interim.