Burnham's Beat

Is There Too Much Venture Capital?

There has been quite a bit of talk in the VC industry lately about whether there is too much venture capital chasing too few quality deals.  Much of the discussion has centered on observations about aggregate growth and total capital under management. For example, in the last 20 years total venture capital under management has grown a whopping 1400% from just under $18BN at the end of 1985 to around $265BN today.  Fundraising, which peaked at $106BN in 2000, was down to $17BN in 2004, but that was still almost 335% higher than 1985’s $4BN.  With growth numbers like these it’s not hard to see why many people feel that there is way too much capital chasing too few quality deals.

Table 1:  US Venture Capital Vs. NASDAQ Market Cap

            New VC   Total VC   Vintage   NASDAQ       VC/
YEAR    Commit   $s Mgmt    Return        Cap      NASDAQ
1985      3,983      17,759       12.9%          287          6.2%
1986      3,896      21,382       14.6%          341          6.3%
1987      4,435      24,694       18.3%          326          7.6%
1988      4,894      26,241       22.0%          339          7.7%
1989      5,599      29,597       19.3%          386          7.7%
1990      3,531      30,536       33.1%          311          9.8%
1991      2,059      29,022       33.7%          508          5.7%
1992      5,385      29,362       34.1%          615          4.8%
1993      3,903      30,636       50.3%          791          3.9%
1994      7,827      35,298       54.4%          787          4.5%
1995      9,973      40,400       88.3%       1,160          3.5%
1996    12,160      48,160       96.6%       1,517          3.2%
1997    19,043      63,154       83.7%       1,935          3.3%
1998    29,676      91,825         8.0%       2,589          3.5%
1999    62,767    148,904      -12.9%       5,205          2.9%
2000  105,801    228,236      -11.7%       3,597          6.3%
2001    37,937    256,890      -11.1%       2,900          8.9%
2002      3,821    258,479        -8.0%       1,998        12.9%
2003    10,613    257,529      -12.7%       2,988          8.6%
2004    17,325    265,000                        3,700          7.2%
CAGR                    14.5%                       13.6%

Notes: 2004 VC capital under management is my estimate.  All #s in Millions, except for %s and NASDAQ #s.
Sources:  NVCA, NASDAQ

It’s All Relative
However, as the table above shows, simply using aggregate statistics about the growth of capital under management is somewhat misleading.   First off, the 1400% growth in capital under management over the last 20 years actually pencils out to a cumulative annual growth rate of 14.5% which is very strong, but not exactly torrid.

Second, and more importantly, you have to put venture capital’s growth into a broader context to really draw any conclusions.  One way to create such a context is to compare venture capital to the public markets on the assumption that venture capital is closely tied to the public markets because public markets are the primary source of VC liquidity.

When you pencil out such numbers you make some interesting discoveries.  Over the past 20 years, the venture capital under management has averaged about 6.2% of the NASDAQ’s total market capitalization.  (Using the NASDAQ as a comparison point makes sense because it is the primary venue for venture backed technology and healthcare companies.)    In 2004 specifically, the estimated $265BN in venture capital under management represented about 7.2% of the NASDAQ’s $3.7 trillion market capitalization compared with 6.2% in 1985.  This means that on a relative basis, there is only about 20% more venture capital in the market today than there was 20 years ago.  Admittedly, there was over 100% more just two years ago, but a combination of greatly decreased fundraising and a somewhat recovered public market have quickly offset that imbalance.

In the grand scheme of things 20% more does not seem like that big an increase in venture capital especially given the relative immaturity of the venture market 20 years ago and the supply-side effects it has undoubtedly created since then.   Given this, at a macro level there does not appear to be a huge over supply of venture capital.

Something Doesn’t Add Up
At a micro-level though, anecdotal evidence often suggests that there is an over supply of Venture Capital.   The social networking space (which I have chronicled before) presents one such example in which not only a large number of deals were funded very quickly but in which many of the deals went off at high valuations even when blue-chip investors, which traditionally have a lot of valuation leverage, were doing the investing.  It’s hard to look at a space like that or anti-spam or storage software and not think to yourself “there is way too much money here”.

Ultimately, I believe both conclusions are right.  At an aggregate level, there is clearly a slight over-supply of venture capital relative to historical levels; however that oversupply should rapidly burn off as the 1999/2000 vintage matures.   In fact, I suspect that in the later half of this decade VC as a percent of NASDAQ market cap will probably be below average, similar to what it was in the mid to late 1990’s which would suggest a clear under-supply of capital at an aggregate level. 

That said, even though venture capital may not be wildly over-funded at an aggregate level, anyone on the ground will tell you that there are clearly localized pockets that are highly over-funded.  I believe that this localized over funding is primarily a consequence of the fact that most VC firms are pursuing what are essentially outdated “flow oriented” business models, an issue which I’ll address in my next post.

North Korea Comes To Wall Street

Try to imagine this:  Your e-mail and phone calls are constantly monitored by a group of people who can at any time block your communications for any reason they see fit.  Everything you write is closely reviewed and liberally edited by people whose sole job is to make sure that you are in strict compliance with government policies.  You can not speak to many outsiders, especially members of the press, without having an official “minder” present.  You can not even speak to many of your own co-workers without first getting official permission and even when you get that permission you must still have an official “minder” present to oversee the conversation.  Worse yet, if you do speak or write publicly, the government reserves the right closely parse whatever you say and charge with your serious crimes if they believe your speech has even slightly deviated from the government declared orthodoxy.

No, you are not a North Korean diplomat or Cuban baseball player, you are a Wall Street analyst.  That’s right, in the name of “protecting” investors, the government, in conjunction with the major investment banks, has conspired to create an Orwellian regulatory “regime” on Wall Street that Kim Jong-Il himself would be proud of.   While the regime differs somewhat by firms, today most Wall Street analysts have all of their communications monitored and often have e-mails, both inbound and outbound, “bounced” without explanation by their compliance departments.  Analysts must get official approval just to talk to their colleagues in their investment banking department and face severe reprimands for having even a simple “Hi, How are you?” conversation with a banker in the elevator lobby.  Even if they do get permission to meet with one of their investment banking colleagues, a member of the compliance department must mediate and oversee the meeting in order to insure that no inappropriate speech is uttered.   Some firms have gone so far as to require analysts to have “minders” present when they speak to the press or even when they visit a private company. One has to wonder: how has a country that prizes the freedom of speech and association as two of its most essential freedoms let those freedoms become so blatantly infringed upon?

The government justifies such infringements on the basis of “protecting” investors from potential conflicts of interest between the research and corporate finance arms of an investment bank.  The basic gist is that unscrupulous research analysts may only say positive things about a bank’s corporate finance clients because they stand to get a cut of the investment banking fees.  Such “false” advice constitutes fraud and therefore opens the door for the government to step in and regulate things.

But this logic has a very, very slippery slope.  If the government is trying to eliminate conflicts of interests in commercial relationships why are they stopping with investment banks?  There are obviously lots of other commercial relationships where consumers are “advised” by parties that have clear conflicts of interest such as:

1. Realtors:  For many, if not most Americans the biggest investment decision they will make is not some Wall Street stock, but buying their home.   In conjunction with this transaction, most people must deal with realtors.  Realtors clearly do not have compliance departments looking over their writings or else classified listings such as “cozy, vintage, bungalow near mass transit” would read “small old shack next to railroad tracks”.  In addition, realtors can have huge conflicts of interest.  Not only do most realtors simultaneously represent both buy side and sell side clients, but if an agent works at Realtor XYZ they often have a vested incentive to show their clients mostly properties from Realtor XYZ and refer clients to their in-house mortgage banker.  Given this, as anyone who has ever shopped for a house will tell you, you should always be careful when dealing with a realtor because you never know when they are only looking out for their own interests.  That’s why word of mouth and reputation are so important in the realty business.  Sure, just like investment banks, realtors must deal with a fair amount of regulation and disclosure, but unlike investment banks realtors are not subject to draconian restrictions on what they write or who they can associate with.
2. Car Salesmen:  Perhaps the second biggest financial decision that most people make after buying a house is what car to buy.  Car salesmen are of course notorious for being less than honest about the cars they are selling and for having lots of conflicts of interests such as dealer-rebates, in-house financing, etc.    However you don’t see the government threatening to throw them in jail every time they lie and say “this model is selling like hotcakes, but I might be able to reserve one for you if you can act today” when they know that their manager told them that morning “get this dog off the lot before the end of the month and I’ll pay you a special bonus.”
3. Waiters:  Many diners often ask waiters “What’s good on the menu?”  This question presents a classic conflict of interest.  Waiters (in the US) receive most of their compensation in tips and thus have a strong incentive to recommend the most expensive item on the menu.  In fact, some restaurant managers are known to instruct waiters to recommend to diners the most expensive meals on the menu.  Applying the government’s security industry rationale to restaurants, any waiter that recommended the filet mignon when they actually felt that the cheaper pasta special was a better dish would be throw in jail.  Of course most consumers know that if a waiter immediately recommends the most expensive item on the menu, they probably don’t have the diner’s best interests at heart.

The point is that almost every commercial relationship in the world is subject to some potential conflicts of interest and the average sentient consumer is already well aware of this.  If consumers feel like they are being taken advantage of, they take their business elsewhere and the reputations of those service providers ultimately suffer.  Those service providers that are known to provide good service despite the inherent conflicts build good reputations which ultimately translate into brands which help build long term franchise value.  Wall Street analysts are no different.  Analysts who screw their clients by advocating bad deals get bad reputations.  Analysts that get a reputation for putting the interests of their clients first, even at the expense of their firm’s financial interests, ultimately have the best reputations.

The only difference with Wall Street analysts is that the government somehow feels that because their commercial relationship involves stocks and not houses or cars, that they have the right to intervene and impose draconian restrictions on freedom of speech and freedom of association.  Given that in the wake of the Internet bubble everyone pretty much hates Wall Street and Wall Street analysts in particular it’s easy to see how the government has gotten away with this (and the mainstream media, supposed defenders of free speech, have acquiesced to this) but it’s also important to contemplate the very slippery and inconsistent slope we are now on in terms of some of our most fundamental freedoms.

As some of you know, I was at one time a Wall Street analyst, so that is why this subject is near and dear to my heart.  This should not be read an attempt to rationalize or legitimize investment banking conflicts of interest.  I actually am a big supporter of full, clear and prominent disclosure of any potential conflicts and I think that government regulation is this regard is actually a good thing.  However I am opposed to the government either directly or indirectly imposing restrictions on our basic freedoms, especially when it’s crystal clear that the free market ultimately does a much better job punishing those who abuse conflicts of interest and rewarding those who don’t.  The government’s current posture towards Wall Street research represents one of the worst and most mis-guided examples of how the “nanny” state ultimately opens the door to unbridled authoritarianism in the trying to protect supposedly clueless citizens.

Is Open Source Becoming Over-Sourced?

Is it just me or does just about every start-up software company have some kind of open source angle to their story these days?  I can’t count the number of start-ups that I have talked to recently that have the following business plan:  1) We have developed a core piece of amazing software 2) In an effort to make gullible, civic-minded developers around the world donate thousands of hours of free development time to our commercial enterprise we plan to declare that our amazing software is “open source”.  3) Once said gullible developers have freely helped us build out a real application, we plan to lure even more gullible corporations with the promise of “free” open source software only to become fabulously wealthy when said corporations determine that they must give us tons of money for support and maintenance of said software.

Truth be told, I have actually found some of these businesses to be very interesting, but others seem to believe that building a successful software company is simply a matter of changing their domain name from software.com to software.org and waiting for the money to roll in.

Granted, I can see how “grand scale” projects such as operating systems, databases, app servers, and other core pieces of infrastructure software are high profile enough, intellectually challenging enough, and broad enough to attract a large following of open source developers (and serious corporate sponsorship).  However I have a harder time seeing how this applies to niche oriented infrastructure projects and especially to applications.   Is there really a critical mass of idle/motivated developers readily available to pitch in for every conceivable niche software project in the world?  Are developers really so stupid that they will devote all their free time to making someone else rich?

Ultimately I think a lot of these niche plays in Open Source may end up becoming what I’ll call “Over-sourced”.  Sure they may succeed in generating some initial interest in their open source project on check processing software or linear optimization, or what have you, but they will never be able to generate the kind of broad based community support that is critical the long term success of the project.  As a result, their open source community will ultimately fade away and leave them (and their customers) holding the bag with a bloated code base and panicked customers.  Of course that outcome may not be so bad for some of these open source companies as their customers will have no choice but to contract with them for support and they will thus ultimately end up looking like any other mature enterprise software company.

It is in this way that I think Open Source is really just becoming a marketing gimmick for many start-up companies.  It gives them a way to lower the perceived risks of dealing with a start-up by addressing issues such as vendor lock-in and up-front investments head-on.  There’s nothing wrong with that and there are definitely a lot of situations where such an approach might work, but there’s no need to talk a lot of BS about leveraging free development talent and giving away free software because everyone knows there’s no such thing as a free ride, even in the land of open source.

List of Software's Top 10 Trends

This is concise list of the Top 10 Software Trends posts that I did last month.  A bunch of folks asked me to put all the links in one place so here they are:

10. Consolidation
9.  Data Abstraction
8.  Composite Applications
7.  BPEL
6.  Inter-Enterprise Applications
5.  Message Aware Networking
4.  Service Oriented Architectures
3.  Software As A Service (SaaS)
2.  Open Source
1.  XML

Are Online Retailers An Endangered Species?

With the cost and complexity of offering an acceptable online purchasing experience declining dramatically and with search making it possible for suppliers to directly reach consumers, online retailers are increasingly looking like potentially expendable middlemen.

In the physical world, retailers add value to both consumers and suppliers in several critical ways.  First, they have skilled buyers that search the world looking to locate appropriate products which both opens up new markets for suppliers and brings new goods to consumers.  Second, they have large networks of stores that offer consumers a consistent shopping experience and manufacturers an attractive distribution channel.    Third, they use marketing to generate strong brand awareness and consumer demand.  Fourth, they use merchandising skills to increase sales and improve the overall shopping experience.

Initially, most of the “value add” of physical retailing translated well to the online world.   Early on it was incredibly difficult from both a technical and operational standpoint to build and operate an online store with a decent shopping experience.   Not only did building a credible website take a lot of money, but building out the back-end fulfillment infrastructure necessary to actually ship products to consumers was also prohibitively expensive.  That made the few online retailers that got it “right” very valuable distribution channels to both suppliers and consumers.  Brand also played an important role given the relatively immaturity of the channel and significant consumer concerns regarding the security and reliability of online retailing.  This made online retailers with good websites and brands highly attractive to both consumers and suppliers.

Over the past ten years however, a number of new developments have eroded the value-add of online retailers to the point where these days they often add little more than excess costs to the process.    Some of most important developments include:

1. Reduced technology costs:  In the 1990’s it cost a lot of money to build and operate a first class online retailing website.  Not only were hardware and bandwidth costs very high (as outlined in this excellent post), but the costs to hire and retain the few technical people who actually knew how to build and scale a decent website were extraordinarily high (that is if you could even find them).  Today, there are a number of excellent e-commerce software products that can be bought for a relative pittance and the pool of competent technical people that can build and run an online store is exponentially larger.  In fact, some start-ups are even offering “all you can eat” e-commerce services for seemingly insignificant sums compared to what major companies paid just a few years ago.  Take Venda for example.  They will design, build, host, and maintain a truly first class website for a flat fee of $10,000/month.  No up front costs at all. (And they even claim to be profitable.)  If you check out some of their sites such as this one or this one or this one, you realize that ten grand a month certainly goes a long way these days.
   
2. Familiarity:  At first, only the intrepid few made online purchases.  These days online purchasing is increasingly a mundane mass-market activity.  As a result, consumers are becoming accustomed to the conventions of online purchasing such as the “shopping basket”, the “checkout process”, the confirmation e-mails, the package tracking, etc.  As the online shopping experience becomes routine, consistent, and predictable across websites, consumers are bound to become increasingly indifferent to which particular website they make their purchase on thus lowering the value of online retail brands.
   
   
3. Outsourced logistics:  Over the past 10 years a large number of companies have entered the business of offering online retailers outsourced warehousing and logistics.  Competition between these companies has driven down prices and made the business fairly efficient.  Some companies, such as GSI Commerce, have even gone so far as to bundle outsourced logistics with hosted websites thereby dramatically reducing the start-up costs for an online retail presence.
4. Search:  In the early 1990s search technology was relatively poor and largely limited to site level-directories.  Google changed all that by creating a much more comprehensive and relevant search experience.  This has now made it possible for detailed product-level searches that reveal not only comprehensive product information, but also a large number of potential purchasing channels. Search, in effect, devalues online retail brands by enabling consumers to think and act in terms of products rather than sites.  Yes, a brand can still stand for things like “great customer service”, but when retailers are selling the same product via a very similar web experience and in some cases even the same fulfillment and logistics back-end, trying to convince a consumer that they are should pay a higher price for choosing one site over another is a hard sell.   

Going Direct?
For suppliers, the Internet’s low costs and universal reach combined with search’s ability to readily generate high quality sales prospects presents a tempting opportunity to cut out the middleman.  In the past, suppliers have been loath to “go direct” to consumers for fear of alienating their powerful retail partners.  Even today many suppliers still just have “product information” websites and refer potential purchasers to retail partners or if they do sell their products on their website they sell them at full list price  (which is typically much higher than the “street” retail price) in order to prevent any “channel conflict”.

However as the internet becomes a universal mass-market channel, suppliers have to wonder whether or not it is really worth it to allow online retailers to mark up their goods by 30%, 50%, even 100%.  Why not cut their retail prices by 15-25% and go direct to consumers?  This would have been suicide when the Internet was such an immature channel, but now that the Internet is a mass market channel there’s a chance that any sales lost to the retail channel (both online and offline) will be more than offset by the additional margin generated by a “direct to consumer” Internet channel.

What’s A Online Retailer To Do?
For online retailers then, the writing is on the wall:  If they don’t figure out new ways to add value to consumers they are in deep trouble.  Indeed, even if their suppliers don’t go direct, the same trends that make such a move possible also make it incredibly easy for incremental retail competitors to enter the market.  So online retailers face two rather unappealing fates: they will either get undercut by their own suppliers on pricing or face increasing competition from a bunch of low-cost “me too” sites.  The odds-on bet is that they will ultimately face both. 

Fighting these trends will require some creative thinking.  At the highest level online retailers will have to focus on how they add value to consumers and suppliers outside of just distribution and brand.  For example, some online retailers may find may need to build out extensive lines of private label merchandise (a la Sharper Image), or they might find it necessary to build customer loyalty schemes (a la Amazon’s shipping subscription).  In any event, they will find it necessary to do something, because in the absence of doing something they will eventually end up in the middle of nothing

Super Services, Process Portals and the Road to Composite Applications

Publicly accessible web services seem to be proliferating like rabbits days.   Not only are high profile early adopters such as Amazon.com, Ebay, Google and FedEx launching a plethora of new services, but an increasing number of more obscure firms are throwing their hats into the ring, offering everything from commodity futures prices to bible quotes.

Super Services
Theoretically, this large pool of publicly accessible web services should foster the creation of a new class of “super services”.  Super services simply combine several different web services into one master service.  They can be custom-designed to serve the needs of a specific company or be repackaged and offered to the public as yet another service.  In fact, there are already some interesting examples of enterprising developers stringing together a few web services to create a rudimentary websites which themselves could be exposed as super services such as this "mashup" of Amazon/Google/Yahoo, this mixing of Flickr and the US Government's zip code database, and this combination of Google Maps and Craigslist.

Unfortunately, creating a true super service is much harder than these early examples might suggest.  To create super services developers must not only link web services at a semantic and programmatic level but they must also find a way to successfully orchestrate a business process across these services in an orderly enough fashion that a basic level of performance and transactional integrity is maintained.   Luckily, emerging business process orchestration technologies, most prominently BPEL, provide a standardized mechanism for creating the process logic underpinning super services.   However, while adding BPEL to the mix has tremendous benefits it also makes the act of building super services even more complex and less accessible.

Process Portals
In recognition of both the increasing number of web services and the increasing complexity of linking them together, a new crop of start-ups has emerged including such companies as eSigma,  Bindingpoint, Xmethods, and Strike Iron.  Initially these start-ups appear to have the rather mundane goal of creating directories of publicly available web services or even libraries of proprietary web services (such as Strike Iron and Xignite have done), but dig a bit deeper and you realize that their ambitions may extend much further.

Take eSigma for example.  I had the opportunity to chat with its founder, Troy Haaland, the other day.  As Troy explained, the simple portal-like interface of eSigma actually hides an increasingly complex infrastructure.  Right now, at the core of this infrastructure is a fully functioning UDDI directory.  All of the services you can browse via the portal are actually formally registered in the UDDI directory making them programmatically discoverable.   The goal is to link this directory core to a higher level process management capability via a BPEL-based visual authoring/scripting platform.  Not only would such a platform allow enterprising developers to easily create and, theoretically re-sell, their own super services, but more importantly it would allow enterprises to create composite applications that exist solely in the “cloud”.  Such “cloud based” composite applications could then be used a back-bone of inter-enterprise applications.

In this way, what appear at first to be simple directories may ultimately be transformed into Process Portals, or sites that not only centralize web services meta-data, but host a set of custom-designed super-services and composite applications as well as the visual authoring tools needed to create them.

The Road Ahead
While this is clearly a long term vision, there are indications that elements of this vision may be closer at hand than one might imagine.  Within the enterprise, there are already a number of products, from companies such as Amberpoint, Blue Titan, and Digital Evolution vying to manage the low-level provisioning and performance of intra-enterprise web services.  As the number of web services multiplies within an enterprise, a directory infrastructure is a logical next step (indeed some products have already taken this step) and some kind of orchestration layer will also clearly be necessary if enterprises want to foster re-usability and enable the creation of super services.   In some ways then, the writing is on the wall: Process Portals are an inevitable result of the increasing number of web services.  The key questions outstanding then are: 1. Will these portals first make their presence felt inside the enterprise as packaged applications or outside the firewall as publicly accessible Process Portals?  2.  Will de novo start-ups be best positioned to own this space or will the pre-existing web services management products “grow” into this space? and 3. Just when exactly will this space generate enough revenue to make it interesting from an investment standpoint?

Virtual Stock Portfolio Update: 3/05

In March my virtual stock portfolio had a relatively decent month with the average position gaining 1.1% compared to the NASDAQ's 2.6% decline.  However the overall portfolio on a position weighted basis was down 0.4% thanks to weak performances from one of it's previous big winners (SportingBet).  For all of Q1, the portfolio was up an 22.9% compared to the NASDAQ's 8.1% decline thanks to very strong performances by my online gambling related longs, combined with solid 10-20% gains by almost all of my shorts.   Of the 12 positions I had in the quarter 8 posted postive returns.

One painful thing I have noted is that I am very bad when it comes to the timing of exiting my positions.  Of the 5 positions I have exited since I started tracking this portfolio in 2/04, all five have generated positive returns since I exited.  3 of the 4 positions are up big (BLUE-L 32%, CNQR-S 32%, RSAS-S 41%).  RSAS is particularly frustrating as I covered that short last month (after making a modest gain) only to have them announce yesterday that they were missing their numbers yet again and having the stock trade down 29%. Ugg.

One of things I mentioned in my year end review is that I have been too slow to sell some of my losers and it is with this in mind that I am making some changes to my portfolio this month.  First off, I am getting out of my long positions in both ACTU and SUMT.  ACTU was a turn-around story was SUMT was a merger synergy story.  While both stocks still trade at very attractive multiples and I like the markets they are in, I don't see a lot of near term catalysts for the stocks and they have both clearly been abandoned by the institutional market.  I might come back to them later, but for now there are better fish in the sea.  I am adding just one new stock, Microstrategy, to the portfolio which will give me an equal # of longs and shorts in the portfolio.

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: This is supposedly a turn around story in the hot business intelligence space. Reporting is becoming more important as more users get access to core business data.   The stock was supposed to recover as a new product release cycle drove license revenues.
Performance: Since 1/26/04: -31.8%, Mar vs. Feb: -11.1%
Comments: Continued poor performance with decreasing trading volume leads me to finally cut and run on this stock.  I still like the valuation and the turn-around potential, but no one else appears to so rather than fight the tape I am going to try and find a long in the BI space with a little more life in it.

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 04. 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).
Performance: Since 1/26/04: -29.2%, Mar vs. Feb: -3.7%
Comments: The stock had a decent Q4 report but quickly gave up much of the ground it recovered indicating very weak support and a lot of stand-by sellers.  The whole e-learning space is in the dog house thanks to the collaspse of Skilsoft.  No sense continuing to fight the trend at both a macro and micro level so I am selling out and moving on.

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: 22.3% Mar vs. Feb: -10.4%
Comments: The stock gave up some ground this month after have a strong Feb/Jan.  I will still hold, but it looks like it may be capped out in the 25-30X consensus EPS range so further price appreciation will have to be driven by upward EPS revisions.  I'll wait one more earnings cycle to see if this materilizes and then pocket what the gains to date.

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: -1.5% Mar vs. Feb: -6.5%
Comments: Traded down with most of the other longs.  Still like the relative valuation.

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Financial Services
Investment Thesis: Every portfolio needs a flier 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: 311.4%  Mar vs. Feb: -1.2%
Comments: Basically a flat month after a blistering Jan/Feb.  Still like the fundamentals despite its pricing becoming a lot more reasonable.

Company: Sportingbet Plc. Ticker: SBT.L
Sub-sector: Internet Gambling
Investment Thesis: portingbet is the largest online gambling operator in the world. 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. 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.
Performance: Since 11/30/04: 72.3%,  Mar vs. Feb: -18.3%
Comments: After being the best performer in February this was the worst performer in March.  Still up 44% in Q1 overall though.   Lots of hot money moving in and out makes this a pretty volatile play.

Company: Microstrategy. Ticker: MSTR
Sub-sector: Business Intelligence
Investment Thesis: I like the BI space in general and have been keeping my eye on Microstrategy.  This is one of the cheaper stocks in the space at 17X earnings, yet it also has one of the better product portfolios and market positions.  From what I hear, businesses are still spending big bucks on BI and MSTR should be a big beneficiary.
Performance: Since 3/31/05: NA,  Mar vs. Feb: NA
Comments: Stock was weak last month when it was announced that the current auditor was resigning the account.  This either created a great entry opportunity or signals an impending accounting scandal.  New auditors often require restatements these days.  Hopefully that won't be the case here as MSTR should have learned its lesson when it comes to accounting by now.   

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. 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: +35.3%  Mar vs. Feb: +8.5%
Comments: Good month to be short anything including Autonomy.  This stock may be played out in the near term though, so I am going to take a hard look at it after its Q1 report.


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: -15.2% Mar vs. Feb: +6.7%
Comments: Good month, but worst performing short in a month made for shorts.  May just be too many people believing the hype on this one.

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: -5.5% Mar vs. Feb +16.5%
Comments: WAVX issued more stock in March, this time selling $4.1M in stock, but at $0.88/share or a whopping 19% discount to the share price at the time.  This comes just 3 months (almost to the day) after selling $5.8M in shares at $1.05/share.   WAVX appears to have closed the deal with the promise that its Q4 results would prop up the stock but it didn't and the stock promptly collasped close to the issue price.  One has to imagine that this well is going to start going dry soon...

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 here...
Performance: Since 11/30/04: -2.2% Mar vs. Feb: +14.7%
Comments: Q4's report seemed to splash a bit of reality water on the faces of the eager retail investors that have piled in here, however I worry that they won't remember this lesson for long.  CNVR takes so long to report their quarters that we won't get a Q1 report until May so there will probably be some more hopeful price appreciate between now and the next reality check.

Company: Manugistics Ticker: MANU
Sub-sector: Supply Chain
Investment Thesis: Manugistics is in a tough spot strategically and financially. Strategically it's facing increased competition from the big ERP players who are successfully bundling more and more supply chain functions into their core offerings.  Financially, Manugistics has a crushing debt load and a negative tangible book of $55M.  It's going to be very hard to pull this company out of the tailspin.  The debt holders may ultimately convert to equity and save the day, but things will have to get a bit worse on the equity front before they are willing to talk turkey.
Performance: Since 2/28/05: +16.4 Mar vs. Feb: +16.4
Comments: Stock was very weak heading into the end of the quarter which would seem to indicate that everyone is expecting a miss.  If they don't pre-announce it should recover a bit in April.

Internet Stocks Update: March/Q1

The Internet Stock Index was off 2.4% in March compared to the NASDAQ's 2.6% loss.  The average stock was off 4.1% as small caps underperformed big caps.  Of the 87 stocks in the universe, March's best performers were DIGI (+73%) which announced it was being acquired by Axiom, EDGR (+30%) which has doubled in the last two months thanks to good financials and improved IR and ASKJ (+22%) which announced it was being acquired by IAC.  This month's worst performers were AOLA (-75%) which announced it was likely to for Bankruptcy, REDE (-52%) which missed its numbers and fired the CEO, and Long (-35%) which missed its numbers in the first full quarter since its IPO.  For all of Q1, the Internet Index was down 16.7% compared to the NASDAQ's 8.1% which seems to indicate that the sector is cooling off quite a bit after a very impressive 2004.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

Software Stocks Update: March/Q1

The Software Stock Index was off 2.9% in March compared to the NASDAQ's 2.6% loss.  The average stock was also off 2.7% with small caps slightly outperforming big caps.  This month's worst performning sectors were PC Games (-15.1%) thanks to weakness at Electronic Arts, E-Learning (-11.6%) thanks to the continued implosion of SKillsoft, and Content Management (-10.6%) thanks to no one in particular.  The best performing sectors were Financial Services (+18.8%) thanks to the Sunguard deal, Digital Media (+8.1%) thanks to Adobe and Operating Systems (+7.7%) thanks a small recovery by Red Hat.  For all of Q1, Software stocks were down 10.2% compared to the NASDAQ's 8.1% which is consistent with the conventional wisdom that Q1 is typically the hardest quarter for software stocks.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

Is Microsoft Becoming IBM?

Quick name this company:  It has been one of the fastest growing companies in America for the last 20 years.  It is now arguably the most powerful technology company in the world.  It is feared by its competitors and grudgingly tolerated by its customers.  It invests massive sums into a research division that has some of the best computer science minds in the world.  It has been sued for anti-trust violations and anti-competitive practices.  It has entered into a government consent decree that limits its freedom of action.  It has been so successful in its core business that it now finds itself increasingly looking for other areas of growth.

If you answered Microsoft, you’re wrong… sort of.  The answer is actually both IBM, circa 1975, and Microsoft, circa 2005.  In fact the parallels between the IBM of old and the Microsoft of today are in many ways so similar that it’s really kind of spooky, especially so given that Microsoft in large part has IBM to thank for its current ascendancy.

Like IBM, Microsoft dominates its core business to the point that it is able to generate tremendous margins and cash flow.  Similarly, Microsoft’s success has created major problems including a massive government investigation and an anti-trust judgment that has placed significant restrictions on its business.  These restrictions in many ways are forcing Microsoft to become more introverted, such as making it more attractive to develop new technologies in-house rather than acquire them because the government is likely to try and block any significant acquisitions.

Combine these traits with a stock that is in transition from a pure growth story to a earnings and income story and you pretty much have carbon copies of each other simply separated by 30 years.

For Microsoft executives they must find the parallels very unnerving, for they know all too well how the IBM story goes:  IBM became so big and myopic that it unwittingly almost gave away the store to a no-name supplier (Microsoft) that ultimately became one of their toughest competitors. By the early 1990’s IBM was in such bad shape that it almost imploded from its own strategic missteps and mismanagement.  These days IBM is in much better shape thanks largely to its near death experience which profoundly affected the company and in many ways made IBM much more humble and much more willing to consider outside ideas.

Granted, becoming IBM isn’t necessarily a bad thing, especially becoming the IBM of 2005.  The key then for Microsoft is to avoid the near death experience that IBM needed to survive.  Right now there’s no suggestion that Microsoft is even close to such an experience, but the potential for such an experience arguably exists the larger, more powerful, and more introverted Microsoft becomes.   Just ask IBM.